8.25 Questions

Question 1:  How does clean surplus accounting measure income?

Question 2:  What is the main difference between Accounting Income and Comprehensive Income?

Question 3:  In the fourth major accounting statement, Consolidated Statement of Shareowners’ Equity, required by the SEC in a 10-K report, one of the line items is “Accumulated Other Comprehensive Income (Loss).”   Name three items that typically appear in this statement.

Question 4:  In the 10-K report filed with the SEC two major statements are the Consolidated Statement of Income and the Consolidated Statement of Shareowners’ Equity.  Which statement reflects clean surplus accounting?  Provide precise reasons in support of your answer.

Question 5:  What is the major difference between Comprehensive Income and Residual Income?

Question 6:  Define in general terms the concept of intrinsic value using residual income as opposed to dividends.

Question 7:  Suppose you are valuing a stock that does not pay accounting dividends.  Can you use the residual income model of intrinsic value to value this stock?  Provide reasons in support of your answer.

Question 8:  Define briefly and then describe the difference between “EPS” and “CEPS”?

Question 9:  Describe precisely the role played by the Book Value per Share and the Cost of Equity Capital or discount rate when estimating Residual Income?

Question 10:  Define what is meant by the term “opportunity cost?”

Question 11:  Accountants work with different concepts of income.  Is the economist’s concept of an opportunity cost used to measure income for the following three concepts of income:  “Net Income,” “Comprehensive Income” and “Residual Income?”   Provide brief reasons in support of your answers.

Question 12:  Define the Return on Common Equity when adopting a Residual Income approach to valuing a stock.

Question 13:  Define and briefly describe the meaning of the term Residual Earnings (Income) Excess Return.

Question 14:  Discuss whether the growth in EPS (Earnings per Share) is the same as growth in CEPS (Comprehensive Earnings per share).  Provide reasons in support of your answer.

Question 15:  Financial analysts provide forecasts of a stock’s Earnings per Share and financial data sites widely report consensus forecasts.  Suppose you need to forecast growth rates in CEPS (Comprehensive Earnings per Share) and you want to base this on the consensus analyst forecast for EPS (earnings per share).  Would you use the same number for CEPS?  Provide reasons in support of your answer.

Question 16:  In a two stage growth residual income valuation model describe how you would estimate stage 2 growth for a stock (i.e., the Normal Growth Rate).

Question 17:  Describe precisely how a firm’s dividend policy is taken into account when applying the Residual Income Valuation model?  If it is not taken into account provide reasons in support of your answer and if it is taken into account describe precisely how and provide the economic arguments in support of how it is taken into account.

Question 18:  Suppose you are analyzing two stocks – stock A has a dividend payout ratio of 50% and stock B has a dividend payout ratio equal to 0.  Assuming these stocks are similarly in other ways which stock will attract the larger adjustment for opportunity costs when applying the residual income valuation method, stock A or B?  Provide reasons in support of your answer.

Data for next three questions

The following provides the Consolidated Balance Sheet for Coca Cola from their 2010 10-K:

And suppose the relevant inputs for KO for computing CAPM are:

Question 19:  What is the book value of equity per share for KO (2009, 2008)?

Question 20:  Assuming CAPM applied to the above screen, what is the implied difference between Comprehensive Income and Residual Income for 2009 per share given the information provided above? (Provide supporting reasons).

Following Questions:

Suppose you are given the following additional information for KO:

Question 21:  By referring to only 2009 data estimate (using the information provided for the previous two questions plus the additional information provided for this question).  What is Residual Income per share for KO for the year ending 2009?

Question 22:  Suppose you are assessing 2009 Residual Income to assess intrinsic value for KO.  By referring to all data provided (i.e., including 2007, 2008 and 2009) data how would you change your answer to the previous question.  If there is no change, provide reasons in support for this position and if there are changes then provide reasons in support of this position.

Real World Exercises: Assessing Intrinsic Value Using the Residual Income Valuation Approach

Select two companies from the Current FTS Dataset that are competitors, or at least are in the same industry even if they do not directly compete with each other. 

Prepare an analysis of each stock’s intrinsic value by applying the Residual Income Valuation Approach.  You should identify the major inputs you need from the Valuation Tutor’s Calculator. 

This model requires estimating the growth rates for projecting Comprehensive Income 1 year ahead, 2-year ahead and for the next n-years depending on how many years you define stage 1 to be and then finally the normal growth rate.  In addition, you need to assess the discount rates (i.e., cost of equity capital inputs). 

You are recommended to first refer to the real world projects at the end of chapter 4 when completing these parts.

Identify the major inputs required to assess the intrinsic value using the Residual Income approach including the important assumptions you have made to come up with this assessment.  You should discuss issues that arose when implementing this model.  That is, what are the critical variables that underlie your analysis and how reliable do you assess your estimates for these variables to be when valuing your two stocks. 

What is the intrinsic value for your two stocks and what is your forecast of Expected Return (Implied Expected Return in the calculator).  These are the calculated values from the Valuation Tutor calculator.  In addition, the support working for how these numbers were arrived at is provided in a support window. 

You are encouraged to refer to the text to understand how these numbers have been arrived at.

Bottom Line Requirements:

1.       What is your bottom line analyst recommendation for your two stocks?  This should be a recommendation that can range from: Strong Buy, Moderate Buy, Hold, Moderate Sell, and Strong Sell.

2.      What is you forecast for the future stock price in 1-year’s time?  Hint:  Apply the Expected Return calculated in Valuation Tutor and multiply by the spot stock price such that the forecast price equals P * (1+E(Return)^1-Year