Valdez Plastics is expected to have a return on equity (ROE) of 15 percent for the next five years and 10 percent thereafter, indefinitely. Its current book value per share as of the beginning of year 1 (i.e., the end of year 0) is $8.50 per share and its required rate of return is 10 percent. The premium over book value at the end of five years is expected to be 40 percent. All earnings are reinvested. The sum of the present values of the residual income estimates over the next five years is $2.10. The projected ending book value in year 5 is $17.80. What is the value of Valdez Plastics using these inputs? A) $13.83. B) $4.15. C) $15.02. D) $10.60. answer is C) $15.02. Applying the finite horizon residual income valuation model: V0 = B0 + sum of discounted RIs + discounted premium = 8.50 + 2.10 + [(0.40)(17.80)/(1.10)5] = $15.02 Can someone tell me the intuition behind using “discounted premium”?? Thanks.
The premium like the terminal value you will get at the end of your high growth phase, beginning of your stable growth phase. This is in year 5 , so you have to discount it back to today’s value at the 10% discount rate. Using this method of terminal value is similar to using the multiples method in DDM or FCF models…
how about this: the value of the firm is current book value plus “added value”. the added value is a measure in perpetuity of what the firm can do. you know the first 5 years are adding $2.10 in residual income (i.e. value for those 5 years). so what are they adding after that? book value is 17.8 (not added value just an accumulation of what they started with and what they added) and then the premium over that is what the market expects that they can add in perpetuity. so, take todays book value and the pv of ALL expected value added (2.10 + .4 * 17.80) and you have today’s price
premium = market value - book value = present value of future residual incomes //you have to discount it because the “present value” is 5 years from now