Residual Income


Please can someone explain why the Answer in the following Q is discounting the premium even though the question already says the “PV of continuing RI is $7.00” - surely that means PV (i.e. value NOW!) and not the Value at Yr 5??

Red Shoes’s recent financial statements reported a book value of $11.00 per share; its required rate of return is 9%. Analyst Tony Giancola, CFA, wants to calculate the company’s intrinsic value using a multistage residual income with a high-growth RI for the next 5 years. Giancola creates the following estimates:

  • PV of interim high-growth RI for the next 5 years is $ 2.90
  • At the end of year 5, the PV of continuing RI is $7.00
  • Estimated Book Value in 5 years is $14.00 Which of the following is closest to the current intrinsic value of Red Shoes? A) $20.90. B) $9.90. C) $18.45. Answer:
  • Applying the multistage residual income model: V0 = B0 + PV of interim high-growth RI + PV of continuing RI = 11.00 + 2.90 + [(7.00) / (1.09)5] = $18.45

Read it carefully, your question says that " At the end of year 5 , the PV of continuing RI is $7.00". Which means that the value of your RIs for the years 6,7,8,…is $7.00. Now, you discount this value to get the PV of $7.00 at T0.

To me it sounds like the PV of a perpetuity 5 years from now on an on-going basis.

answer is absolutely correct…I suggest you draw timelines for multiperiod models throughout the CFA…makes it clear.