I am currently doing equity part in Mock exam. I saw in the answer part that the residual income in the next year = residual income in this year * (1+ g) with g equal ROE in this year * retention rate.
I dont understand the basics of this formula. I just know the traditional way to calculate RI is to use Net income- equity charge.
Can anybody explain for me the former formula? Thank all of you in advance. Super s2000 plz help!
It’s the perpetual formula (terminal value) for the RI valuation method. RI is what’s lefts of earnings-equity charge, and that’s your add value that you discount for in this case. Other valuation techniques may use free cash flow to equity, or dividends instead. But the concept is the same, and they will all give you the same final valuation for equity, if all the assumptions are consistent.
Usually, that’s not the proper way to do it, since assigning a ROE above the COE is unsustainable on a permenant basis, and will overestimate your final value. This is why there is a couple of ways (one of them in the CFA) to account for that by inlcuding a factor for speed of reversion of ROE towards COE. I personally do a negative growth in the denominator, and no growth in the numerator, but that’s outside the scope of the material.
Traditional formula is similar to all other formula you’re refering to i.e if you’re trying to Say that another formula Ri=E-(r*Bo), where r*Bo is what we call Equity Charge. You can use any formula and you’ll end up with same answer.
Try to look equity as a whole not in part. In this way you can solve any question(hopefully).
and before jump to Mock exam do proper revision otherwise you’ll loose the real benefits of Mock exams.