The Concept of Residual Earnings

By Matthew Scullen

It is the duty of the equity analyst, more specifically the common stock analysts, to determine the value of a company, its intrinsic value relative to its current market capitalization and determine if their is a margin of safety in between these two values. Of course, this assumes you follow the traditional Graham & Dodd value strategy. Without getting into investing philosophy and sticking strictly to valuation, let's consider the differences between some of the more popular strategies (all of these strategies assume statements have been reformulated so that operating and financing items have been separated):

Discounted Cash Flow Analysis:
Free cash flow (FCF) is calculated easily by finding the difference between Operating Income (OI) and the change in Net Operating Assets (^NOA or NOA1 - NOA2) or FCF = OI - ^NOA

The FCF forecast model uses FCF now and estimates into the future discounted by the Required Return on Capital (RC). The RC is calculated using the stock's Beta, the risk free rate of return (usually 3 mo. t-bill), and a market risk premium (expected return on the market - risk free rate). This calculation is made however many years out the forecast is intended to extend to, maybe 3-5 years. So it looks like:

Value = FCF/RC + FCF2/RC2 + ..... + FCFn/RCn + CV

The last part of the formula, CV, is the continuing value, is an estimate of value for a finite forecast horizon of FCF's. It is calculated as follows: FCFn+1/(RC-1) or if you forecast FCF to grow at a constant rate then FCFn+1/(RC-g), where g is 1 plus the forecasted rate of growth in FCF.

The problem with using discounted FCF is that it does not measure value added. FCF is a measure of stocks and flows. The analysis charges this flow of money with the required return on capital. Assume a company makes a large investment and as a result ends a quarter with negative cash flow. Value is not derived from this figure and cannot be accurately forecasted, but in the long run there is potential value added from the cash investment. FCF does not measure this.

The Residual Earnings Forecast Model:
First, let's define residual earnings (RE); RE = Return on Common Equity (ROCE) - RC * Common Shareholders Equity (CSE)

So what does this measure exactly? This measures the return to shareholders above the required return on capital. The discounting process is the same as with FCF, where a CV is used at the end, but RE is used instead of FCF; V = CSE + RE/RC + RE1/RC1 + ... + REn/RCn + CV.

One important note must be accounted for; this model can only be used when there is no debt recorded on the books. Otherwise debt acts to lever up ROCE, distorting real value added.

So here we have a cleaner forecast, one that determines whether value is being added in earnings. You can tell by the difference in ROCE and RC. If it is positive, RE will be positive and value is added. The opposite is true if ROCE is less than RC.

Again, debt distorts this forecast, in which a different formula will be needed, but I will not cover in this particular article. Also, beware of long forecasts, the longer the time horizon the more speculative in nature it becomes. For this reason, I do not forecast out beyond the current year and scrap the CV.

If you have any comments or suggestions, especially with regards to the use of risk free rates and expected returns on the market, please comment here.

About the Author:
My name is Matthew Scullen, I am a financial administrator for an independent investment representative.

I currently keep a daily blog, http://capitalhd.blogspot.com/ titled Capitalism...Now In HD, an analysis of economics, the Fed, Investing and markets.

I have a degree in economics and I am an amateur investor, preparing to be licensed as an Registered Investment Adviser. I am drafting business plans for my own investment management firm.