How To Value A Company Using The Residual Income Method

June 15th, 2015

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This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

On the third Monday of each month, Ill comment on the performance of the premium portfolios and provide some additional analysis related to individual stocks. In this article, I will use the example of a regional bank to illustrate how to value a company using a method called the Residual Income method.

Premium Portfolio News

The performance of MoneyGeek's premium portfolios for the month of May 2015 were as follows:

May 2015Last 12 MonthsSince Apr 2013
Moderately Aggressive -1.5% +6.2% +28.5%
Very Aggressive -4.6% -8.4% +13.4%
Extremely Aggressive -7.8% -25.4% -3.9%

Because the premium portfolios consist of U.S. and Canadian stocks, it makes sense to compare the results against the S&P 500 and the TSX Composite, which are the most widely used U.S. and Canadian stock market benchmarks, respectively. In May, a hypothetical portfolio of 50/50 Canadian and U.S. stocks would have returned +2.8%, so premium portfolios underperformed in May.

Although the performance of the extremely aggressive portfolio has been rather poor, please keep in mind that the portfolio should add 25% to its performance if LRE trades at the same price it did in December. Despite the fact that the company is in better shape now, its stock is trading at half the price it was back then. Unfortunately, I dont control the stock price or the decisions of other investors.

The greatest fear I have with regards to LRE and BXE is that their management will do something stupid. For example, I would not be happy if either company decides to sell the whole company at their current low valuations. Alternatively, management could issue new shares at these prices in an overzealous attempt to reduce some of their debts, but doing so would hurt existing shareholders. While I dont think management of either company will make any of these mistakes, it is possible that they could.

You should note that these mistakes would be mistakes only if LRE and BXEs share prices are undervalued. If their share prices are overvalued, selling the company or issuing shares would actually benefit existing shareholders. The question then follows - how does one go about valuing a company?

In this article, I fully illustrate the method I use to value a company. I will use the example of NKSH, which is a regional bank in the U.S and which forms part of the premium portfolios, to explain how the valuation method works.

The Rationale Behind The Residual Income Method

To value most companies, I use a modified version of the Residual Income (RI) method. The RI method divides the value of a company into two components. The two components are book value, and the sum of future residual incomes.

Book value is an accounting concept that refers to the companys assets less liabilities. In other words, it refers to the amount that shareholders would receive if the company sold all its assets and paid all its obligations at the amounts stated on their financial statements.

However, the problem I see with this textbook approach is that assets and liabilities rarely fetch the amounts stated on the financial statements. I touched on this point with regards to real estate assets in my last premium only article.

This is why I believe it makes more sense to use liquidation value. Liquidation value refers to the amount of cash that assets would fetch minus the amount the company would have to pay to cancel all its obligations. In other words, its the amount of cash that shareholders would receive if the company decided to close shop today.

The second component of the RI method is the sum of future residual incomes. Residual income in a given year is defined as a companys earning minus the equity charge. You can think of equity charge as the cost of not liquidating the company today. Let me explain.

A company that has a positive liquidation value has two choices. It can either liquidate the company today and return money to its shareholders, or it can keep its assets to earn more money in the future.

If the company chooses to liquidate, its shareholders can invest cash elsewhere and earn returns on it. But if the company chooses to keep its assets, shareholders cant invest that money elsewhere. This cost of not being able to invest the money is the equity charge.

A company adds value to the shareholder by the amount it earns in excess of the equity charge. This difference between a companys earnings and the equity charge is the companys residual income, and the sum of all residual incomes factor into the valuation of the company.

While the principles of this method are sound, I again modify the approach in practice. As Ive explained before, a companys earnings as stated on its financial statements is often misleading due to accounting quirks. Therefore, I think its better to use an adjusted method that uses cash flows instead of earnings as a companys true measure of profitability. Also, I believe that it makes more sense to calculate the equity charge based on the companys liquidation value as opposed to book value.

Valuing NKSH

Now that Ive explained the theory and how I modify it for my own use, let me show the RI method in action using National Bankshares (NKSH). NKSH is a rather easy company to model using the RI method because most of its assets are valued at market prices on its financial statements. This removes the need to adjust the financial statements by much.

Ive constructed a spreadsheet that shows the liquidation value, cash flows, and the value of NKSH calculated using the RI method. You can access the spreadsheet in the link below.

NKSH Spreadsheet

If you look at the Liquidation Value sheet, youll notice that Ive made adjustments to only two items to arrive at the liquidation value. Specifically, Ive set Intangible assets and goodwill and Other assets to zero. Intangible assets and goodwill have no market value by definition, so a value of zero makes sense. Im not sure whats included in Other assets so I chose to be conservative and set it at zero as well. As of the end of March 2015, I estimated that NKSH had a liquidation value of $166.8 million.

In the Cash Flow sheet, Ive reproduced earnings and cash flows for the last three years, as well as my estimate for a normalized year. Like most other types of companies, banks have good years and bad years, so its important to smooth out the numbers by taking the average when appropriate.

The only category I made a big adjustment to is Intangible assets amortization. This expense is purely an accounting concept that doesnt involve any cash outlays, so I excluded it from my calculations. This item will soon disappear from the official financial statements, anyway.

After all the adjustments have been made, I came to estimate that NKSH would have generated $17.6 million worth of cash flows in 2014, if the year had been a normal year.

Finally, Ive incorporated everything in the Valuation sheet to calculate the value of NKSH according to the RI method. Youll notice that there are a few terms we havent talked about, so let me explain those now.

First, let me explain what the return on net tangible assets is. This term refers to the amount of cash flow generated each year per liquidation value. Looked at another way, it measures how productive a company is with shareholders money. A more productive company can use new cash generated each year in order to grow its cash flows faster compared to a less productive company.

The return on net tangible assets is multiplied by the proportion of cash flow retained by the company to arrive at the growth rate of cash flow. To see why we need to multiply by the cash flow retained, imagine that the company doesnt retain any of the cash flow it generates (i.e. it pays it all out in dividends). In this scenario, the company doesnt have any new cash to invest in the business, so it cant grow its cash flows. Conversely, a company that retains most of its cash can invest in many new opportunities.

To estimate the return on net tangible assets for NKSH, I looked at the long term history of cash flow to liquidation value. A value of 12% seems to be the norm for the company.

Another term, the discount rate, measures the rate of return we can get by investing elsewhere. This rate is important because it is what we can expect to receive if the market price of the stock equalled the fair value of the stock.

For example, lets say that a companys fair value is $10 per share using a discount rate of 8%. That means we will receive a return of 8% per year if we could buy the shares at $10.

In NKSHs case, Ive used a discount rate of 10%, and this results in a fair value of roughly $33.2 per share. On the other hand, if we move the discount rate up to 11%, the fair value goes down to $25.4. By comparison, NKSH shares traded at roughly $29.31 per share, which means that if we invested at current market prices, we would realize a return of between 10 and 11% per year.

While 10 to 11% per year doesnt sound that exciting, its actually a lot better than what I believe the average stock will return in the long run. Some stock market models forecast that the average stock will return roughly 4% per year for the next 10 years. If this is true, and if NKSH returns 10%, NKSH will essentially outperform the stock market by 6% per year.

However, whether NKSH will actually return between 10 to 11% per year will depend on NKSHs business. If the business does poorly in the future in comparison to how it did historically, then we can expect NKSH to return less than 10% per year. Of course, we can expect NKSH to generate higher returns if the converse is true.

However, NKSH has generated rather stable earnings in the past, and I personally expect this trend to continue. This stability, while boring, is also what makes this investment more appealing since it balances out some of the other stocks that are more volatile.

This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

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