E5.9.

Residual Earnings Valuation: Black Hills Corp

The pro forma for the exercise is as follows:

Eps
Dps
Bps
ROCE
RE (11% charge)
Discount rate (1.11)t
Present value of RE
Total present value of RE to 2004
Continuing value (CV)
Present value of CV
Value per share

1999

Forecast Year
____________________________________
2000
2001
2002
2003
2004

9.96

2.39
1.06
11.29
24.0%
1.294
1.110
1.166

3.45
1.12
13.62

2.28
1.16
14.74

2.00
1.22
15.52

30.6%
2.208
1.232
1.792

16.7%
0.782
1.368
0.572

13.6%
0.379
1.518
0.250

1.71
1.24
15.99
11.0%
0.003
1.685
0.002

3.78
0.0
0.00
13.74

a. ROCE and residual earnings are in the pro forma

b. If ROCE is to continue at 11% after 2004, then residual earnings are expected to be zero.
The continuing value is zero. The value is $13.74 per share a Case 1 valuation.
c. As the CV = 0, the target price is equal to forecasted bps of $15.99 at 2004.
E5.11. Valuing General Electric Co.
a. Here is the pro forma using a required return of 10%.
2004
EPS
DPS (dividend payout 50%)
BPS
10.47
RE (10%)

2005
1.71
0.86
11.32
0.663

2006
1.96
0.98
12.30
0.828

The value is calculated as follows, with a 4% growth rate in the continuing value:

Value $10.47

0.663
1
0.828

$23.62
1.10 1.10 1.10 1.04

$10.47

Or,

0.663 0.828
1
0.828 *1.04

$23.62
2
2
1.10 1.10
1.10 1.04
1.10

Extension to E5.11 (related to chapter 7 reverse engineering).

Case A. Given the market price of G.E. is $26.13 at the end of 2004, find the implied growth
rate of residual earnings g-1.
$10.47

0.663
1
0.828

$26.13
1.10 1.10 1.10 g

Solve for g, you get g = 1.05. So the growth rate is 5%.

Case B. Given the market price of G.E. is $30.25 at the end of 2004, (the residual earnings
growth rate remains at 4%). Please find the implied expected return?
Now even without calculation, we know the implied expected return will be lower than 10%,
because the price $30.25 is higher than the value $23.62. The higher the discount rate, the lower
the (present) value.
If you are using excel, you can find implied expected return by trial and error: try 9%, 8.5%, 8%.
You will find the answer is 8%.
Without a computer, you can solve it the following way.
$10.47

0.663 1
0.828

$30.25
ER
ER ER 1.04

With some algebraic manipulation, you will get a quadratic function:

19.78 ER 2 21.26 ER 0.13848 0
ER

21.26 (21.26) 2 4 *19.78 * ( 0.13848)

1.08
2 *19.78