Residual Income Valuation

Correct Answer: The company's return on equity (ROE) is consistently higher than its cost of equity capital.

The residual income valuation model estimates a company's intrinsic value based on its expected future residual income, which is the excess return a company generates above its cost of equity capital. If a company's return on equity (ROE) consistently exceeds its cost of equity, it indicates that the company is generating excess returns and creating value for shareholders. This scenario would result in higher estimated future residual income and, consequently, a higher intrinsic value estimate using the residual income model. An ROE consistently equal to the cost of equity suggests that the company is just meeting the required return, neither creating nor destroying value. This would lead to lower estimated future residual income and a lower intrinsic value compared to a company with an ROE exceeding its cost of equity. An ROE consistently below the cost of equity implies that the company is not generating sufficient returns to cover its cost of capital, which would result in negative future residual income and a lower intrinsic value estimate, regardless of the company's market position or brand recognition.

Correct Answer: The book value of equity is used as a starting point and residual income is added to it to arrive at the intrinsic value estimate.

The residual income valuation model uses the current book value of equity as a starting point. It then adds the present value of expected future residual income to arrive at the intrinsic value estimate for the company. The other two answers are incorrect because: - The book value of equity is not irrelevant in the residual income model. It serves as the foundation to which the present value of future residual income is added. - The book value of equity is not the final intrinsic value estimate. It is just the starting point, and the discounted residual income still needs to be added to it to get the final intrinsic value.

Correct Answer: The persistence factor represents the rate at which future residual income is expected to fade towards the cost of equity capital over time.

The correct answer is that the persistence factor represents the rate at which future residual income is expected to fade towards the cost of equity capital over time. In the residual income valuation model, the persistence factor is used to capture the idea that a company's competitive advantages and ability to generate excess returns (residual income) will typically erode over time due to competition and other market forces. The persistence factor is a number between 0 and 1 that determines how quickly the residual income fades towards zero in the future. The other two answers are incorrect because: - The persistence factor does not imply that a company can maintain its current level of residual income indefinitely. In fact, it assumes the opposite - that residual income will gradually decline over time. - The persistence factor is not used to adjust the book value of equity. Rather, it is applied to the future residual income projections in the valuation model.