- CFA Exams
- CFA Level I Exam
- Topic 5. Equity Valuation
- Learning Module 24. Residual Income Valuation
- Subject 3. The Residual Income Valuation Model
CFA Practice Question
A company has a book value of $5 per share. It is expected to earn $0.60 per share in perpetuity, pays out all of its earnings as dividends, and has a required rate of return on equity of 10%. Calculate the value of the stock using the dividend discount model and the residual income model.
Correct Answer: Dividend Discount Model:
V0 = D/r = 0.6 / 10% = $6.
It pays out all its earnings: BV0 = BV1 = BV2 = ... = BVt = $5.
RIt = E - r x Bt-1 = $0.6 - 0.1 x $5 = $0.1.
Present value of stream of residual income: RIt / r = $0.1 / 0.1 = $1.
V0 = BV0 + Present value of expected future per-share residual income = $5 + $1 = $6.
V0 = D/r = 0.6 / 10% = $6.
Residual Income Model:
It pays out all its earnings: BV0 = BV1 = BV2 = ... = BVt = $5.
RIt = E - r x Bt-1 = $0.6 - 0.1 x $5 = $0.1.
Present value of stream of residual income: RIt / r = $0.1 / 0.1 = $1.
V0 = BV0 + Present value of expected future per-share residual income = $5 + $1 = $6.
User Contributed Comments 2
| User | Comment |
|---|---|
| tengo | use the single stage model with g=0% and roe=12% and bv =5 |
| Rotigga | Or alternatively: ROE = NI / Equity BV = 0.6 / $5 = 0.12 V0 = B0 + (ROE - r) * B0 / r = 5 + (0.12 - 0.1)*5 / 0.1 = $6 |