Residual Income Valuation

[chancornelius]

“Under Scenario 2, it is assumed that share price will be equal to book value per share”
Why this results in the present value of the terminal value, as at the end of 2014, being equal to zero?
Why it is not equal to ending BV at 2014 divided by 1.10^3 ?

 

[JayWill]

You don’t discount book value, but rather a premium over book value based on assumed continuing residual income. In the case of Scenario 2, stating that share price equals book value is essentially saying there is no premium over book value, and that ROE has fallen to the cost of capital thus no continuing residual income. Using the TV formula for a multistage RI valuation (Pt - Bt)/(1+r)^T, Pt (share price) - Bt (book value) = 0, thus TV = 0.