The Japan Analytics App uses Residual Income as the key component in its valuation model. For many this is an unfamiliar concept which this post will try to address.
Residual Income which is also known as ‘economic earnings’ represents the true value generated for shareholders after taking into account their required return. Traditional accounting was originally designed for debt investors and does not include a charge for the use of equity capital. Shareholders are left to determine on their own if their opportunity cost has been covered.
Companies that do not generate excess or residual income over their required return should be considered as destroying shareholder value and should be valued at below book. Companies that create value should trade at a premium.
Calculating Residual Income requires a number of adjustments to be made to the Income Statement and Balance Sheet in order to derive “Core Operating Income” and “Net Operating Assets”. For most companies the former is equal to Gross Profit less SG&A expenses but after an allocation of tax, while the latter requires a separation of operating and financial assets and liabilities. Operating activities are primarily trading with customers and suppliers in goods and services but also include investments in inventories and fixed assets. Financial activities include the raising of cash from and returning of cash to debt providers and equity holders and also the investment of any financial surpluses. In most cases only the operating activities add value to a business and for non-financial companies almost all financial activities should be considered to have zero net present value.
Rather than attempt to calculate a weighted average cost of capital (“WACC”) for each business which can be an exercise in frustration as it requires us to determine the equity risk premium, we have adopted a single required rate of return for all companies of 6%, an amount equal to the long-term rate of return for industrial companies in developed markets.
Residual Income is therefore calculated as follows: –
Core Operating Income After Tax less (Net Operating Assets Y-1 * 6%)
Part 1 of this review will look at Large Cap companies.
The following tables present the top and bottom companies in Japan measured by trailing twelve-month (“TTM”) Residual Income, the change in Residual Income from the TTM period ending one year ago and the percentages of both numbers to current market capitalization. We have excluded financial companies as well as Sony, Rakuten and Japan Post which have large finance-related businesses which distorts their Net Operating Assets. Companies that have not disclosed quarterly data for each of the last four quarters have also been excluded.
TTM Residual Income Descending – Large Cap
29 Large Cap companies had greater than ¥100b in Residual Income in the last 12 months and all but 4 have seem the amount increase. Of those with declining Residual Income, only Bridgestone and Toyota saw their share prices rise over the last year.
Toshiba is ranked second as a result of a strong performance in its remaining core operations (some of which are for sale) and a > ¥1t reduction in its Net Operating Assets. Toshiba’s current Residual Income is the highest in its history since listing. The current stock price implies a perpetual decline in Residual Income of 11% a year which may be accurate if the core businesses are sold. Otherwise capitalizing this Residual Income at 6% more than offsets the current negative book value and offers 240% upside to a no-growth valuation.
Three telecom providers and six auto/auto parts companies head the list but many sectors and peer groups have only company represented. Apart from Toshiba the greatest upside to a no-growth valuation is offered by Inpex, Subaru and Nissan. Only Daiwa House and Keyence are Overbought in terms of our ‘Price Score’, Toshiba being the only stock that is ‘Oversold’.
TTM Residual Income Ascending – Large Cap
The bottom 30 Large Caps list is dominated by electric power, shipping, steel, paper and real estate companies. Of the twelve companies on the list that saw a rise in Residual Income, only Kintetsu. Kawasaki Kisen, Tokyo Tatemono and Tokyu saw less than double-digit share price gains over one year. None of these companies offers any valuation upside.
TTM Residual Income 12-Month Change Descending – Large Cap
The list of top 30 large cap 12-month gains in Residual Income is led by two energy stocks, 5 of the seven sogo shosha and two each from the steel and auto sectors. From this list, apart from Toshiba, Idemitsu, Hitachi, JXTG, Central Japan Railway, and Brother all have more than 50% upside.
TTM Residual Income 12-Month Change Ascending – Large Cap
Apart from the utilities, there are five auto/auto-parts and three pharmaceutical companies on the worst 12-month change list. Only five of thee companies saw double digit price changes over one year which shows that fundamentals still have some bearing on price movements in Japan. Only the auto stocks have decent upside. Note the appearance of Yamato Holdings on the list with a -¥46b shift.
By expressing the 12-month change as a percentage of market cap a few more companies join the list including Showa (175% upside), Modec (146% upside).
TTM Residual Income 12-Month Change % of Market Cap Ascending – Large Cap
Of note here are Heiwa, Oki Electric, Adastria and Kyorin.
Part 2 will focus on Mid Caps.