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American Eagle Apparel Stores. By: Nick Cecero. Residual Enterprise Income Valuation Model. This method estimates value using accounting numbers which are readily available as compared to the cash flow-based valuation model. Is this method superior to the DCF Model?

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residual enterprise income valuation model
Residual Enterprise Income Valuation Model
  • This method estimates value using accounting numbers which are readily available as compared to the cash flow-based valuation model.
  • Is this method superior to the DCF Model?
  • Yes, because instead of using forecasted numbers as used in the DCF Model we are using accounting numbers which allow for a more accurate stock valuation. Also if there are no free cash flows present than the REI Model would be far superior to use as compared to the DCF Model.
are there any other positives to residual enterprise income valuation model
Are there any other positives to Residual Enterprise Income Valuation Model
  • Although it is superior to the DCF Model due to not only its use of actual accounting numbers, but also because it anchors in the sense that if a firm changes its accounting methods the value will of the stock or project will not change otherwise the model would not work.
  • This method demonstrates the central role of the self-correcting nature of accounting.
example of changing accounting choices
Example of Changing Accounting Choices
  • For example, if a company changes the way it computes depreciation no matter what they choose the project value should be the same.
  • This is because if there is an excess of depreciation it will lead to a book value (NEA) that is too low. One would argue that the value of the project would by the end be lower than what was previously calculated under the previous depreciation method. But, because accounting is self-correcting once the depreciation has been accounted for it cannot be taken again and the future earnings (EPAT) will be higher by exactly the amount of excess depreciation.
two values to be calculated
Two Values to be Calculated
  • Finite Horizon Period (Terminal Value) – The first five years through 2018 and these are our explicit forecasts of REI.
  • Period Beyond the Horizon(Continuing Value) – The period from 2019 to infinity. This continuing value as captured by the REI Model will be different from the value that we calculated using the DCF Model. (Enterprise Value will still be the same though)
  • Additional Notes:
  • Discount Rate > Growth Rate (Must Hold True)
  • We will also assume that the growth rate beyond the horizon will be the same as the growth rate in sales of 3%. (Notion is that firm’s growth is driven by its ability to grow sales)
residual enterprise income formula
Residual Enterprise Income Formula
  • V0 = NEA0 + (EPAT1 – (rEnt* NEA0)/(1+rEnt)) + (EPAT2– (rEnt* NEA1)/(1+rEnt)^2) + (EPAT3– (rEnt* NEA2)/(1+rEnt)^3) + (EPAT4– (rEnt* NEA3)/(1+rEnt)^4) + (EPAT5– (rEnt* NEA4)/(1+rEnt)^5) + (1/((1+rEnt)^4)) * (((EPAT5 – (rEnt* NEA4))*(1+g))/ (rEnt-g))
computing the cost of enterprise capital wacc
Computing the Cost of Enterprise Capital (WACC)

rEnt = (0% * ($-488,524/$2,064,016)) + (8.88% * ($2,552,540/$2,064,016))

rEnt= 10.99%

is there a difference between dcf rei models
Is there a Difference Between DCF & REI Models?
  • As shown using two different WAAC estimates one of which was my own and the other was taken from Bloomberg the enterprise values were the same regardless of the model chosen.
which model would i use
Which Model Would I USE?
  • I would use the Residual Enterprise Income Valuation Model as compared to the Discounted Cash Flow Model when and if any of the following conditions are present:

1) Terminal Values are Highly Uncertain

2) Firms that do not have free cash flows

3) Non Dividend Paying Firms

the end
The End

Any Questions?

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