Residual income valuation: OCI and clean surplus accounting

Considering the market’s focus on earnings, other comprehensive income (OCI) can be easily overlooked by investors. We think OCI is always important in equity analysis, but if you use a residual income approach to valuation the requirement for a ‘clean surplus’ in your model makes it vital to consider gains and losses reported outside profit and loss.

We explain clean surplus accounting and why residual income valuations only work if your forecast financial statements meet the clean surplus condition. One aspect of financial reporting where this may be particularly important is expected currency translation differences.

In a recent question about residual income valuations from a Footnotes Analyst subscriber, we were asked how to deal with forecast currency translation differences recognised in other comprehensive income (OCI). This raises wider questions of how OCI (and also non-GAAP performance metrics) affect so-called clean surplus accounting, and the link between clean surplus and equity valuation.

We think OCI is always important for investors seeking to understand company performance. However, it takes on added significance if you apply a residual income approach to equity valuation. For this valuation methodology to give a valid answer, the forecast performance metrics on which it is based (essentially either earnings or NOPAT) must comply with the clean surplus requirement. If they don’t (and you have no compensating adjustment) your residual income model (and sometimes DCF, depending on how it is structured) will be invalid, and the result inconsistent with forecasts for the business.

Clean surplus accounting and OCI

Clean surplus accounting is where all changes in capital (assets less liabilities), other than those arising from transactions with shareholders, are recognised in profit. In other words, no gains or losses by-pass profit and are included directly in equity (or indirectly in equity via OCI). The only items reported directly in equity are transactions with shareholders, such as dividends, share buybacks and other components of the net distribution to (or net capital raised from) shareholders.

Usually, clean surplus accounting refers to the relationship between equity capital (shareholders’ funds) and earnings (profit and loss). Only if the following holds does clean surplus apply:

Equity₁ = Equity₀ + Earnings – (Dividends + share buybacks – share issues)

It is also possible to view clean surplus from an enterprise perspective with invested capital in place of shareholders’ equity and profit in the form of NOPAT¹NOPAT is Net Operating Profit After Tax. It equals the post-tax profit attributable to all providers of capital. NOPAT is the commonly used basis for enterprise free cash flow DCF valuations.. In this case invested capital equals net operating assets, and the net distributions to capital providers equals enterprise free cash flow.

Invested Capital₁ = Invested Capital₀ + NOPAT – Enterprise FCF

We will consider this version of clean surplus when we discuss residual income valuations. For now, let’s just focus on the equity shareholders’ perspective, which is what accountants usually mean by clean surplus accounting.

There are two reasons why clean surplus fails, either because something other than transactions with shareholders is reported directly in equity, or because of gains and losses being reported in OCI. The former is relatively rare, the main examples are prior period adjustments arising from changes in accounting policy and some taxation amounts arising from stock-based compensation²We explain the tax effect of stock-based compensation (and the difference between IFRS and US GAAP) in our article ‘Effective tax rates and stock-based compensation’.. However, the reporting of gains and losses in OCI is very common and affects most companies in one way or another.

Although some companies regard items in OCI as being recognised directly in equity (and not gains lor losses at all), this is not the case. OCI is a component of comprehensive income and in our view should be regarded as part of performance (although these gains and losses may have quite different characteristics).

Comprehensive income (earnings plus OCI) will almost always show a clean surplus. However, comprehensive income is rarely used as a measure of performance, with companies and investors preferring earnings (or a subtotal component of earnings). As a result, OCI is a cause of dirty surplus (i.e. a lack of clean surplus) accounting.

In addition to an equity or enterprise perspective, the term clean surplus accounting can refer to either periodic profit or to aggregate profit over the lifetime of a business. In periodic profit terms, any amounts recognised in OCI, whether or not they are subsequently recycled, means that clean surplus fails. It is this perspective that matters for residual income valuation. However, accountants often use the term clean surplus in respect of aggregate profit. In this case clean surplus is satisfied if all gains and losses recognised in OCI are recycled into profit and loss in some future period.

For example, IFRS (but not US GAAP) permits the changes in value of equity investments that are reported at fair value to be recognised in OCI, but prohibits their recycling. This means that both periodic and aggregate earnings fail clean surplus. However, currency translation differences  initially recognised in OCI are recycled when the related subsidiary is sold and affect earnings at that point. Clearly this could be many years hence but, in principle, clean surplus (for aggregate earnings) is satisfied eventually. However, it is clean surplus in each period that matters for residual income valuations, which is why currency translation differences require careful monitoring. 

Whether financial reports should reflect the concept of ‘clean surplus’ accounting and the implications for the use of OCI divides opinion amongst accountants, particularly standard setters. Some argue that clean surplus is best maintained by not using OCI in the first place and that all gains and losses are best reflected in a single performance statement. Others argue that unrealised remeasurements are best initially reported in OCI, but once these gains are realised they should be recycled to profit and loss, therefore maintaining clean surplus at the aggregate level. However, this is all somewhat academic – investors just need to deal with the current requirements.

OCI and analyst forecast financial statements

Although there are several types of gains and losses recognised in OCI, the incidence of OCI in analyst forecast models should be lower than in historical financial statements. Many OCI items are value changes for which the most likely forecast may well be zero. For example, currency translation differences will often be assumed to be zero in a financial statement forecast model on the basis that it is difficult to predict currency fluctuations.

However, your forecasting model may well still include OCI items. In the case of currency translation, if a company has foreign subsidiaries in a jurisdiction with a materially stronger or weaker currency, ignoring translation differences may not be an option. To get the right growth rate, and one that is consistent with the discount rate applied in valuations, the expected foreign currency appreciation or depreciation will almost certainly need to be considered. This will lead to OCI gains or losses in forecast periods, thereby violating the clean surplus assumption.

You might also include forecast OCI items in the case of value changes. This is likely for holdings of equity investments reported using the FVOCI option, debt instruments reported at FVOCI and (at least for IFRS) the excess expected return on pension assets. If, for example, you are analysing a company with material equity investments reported using FVOCI, to obtain realistic forecast financial statements, you will likely make an assumption about the growth in these investments. This will result in a gain in OCI, which could be problematic for residual income valuations.

Residual income valuation

Residual income is profit after deducting a cost of capital charge in respect of the capital employed in the business, usually applied to the capital at the start of the accounting period.

Residual income₁ = Profit₁  –  Accounting Capital Employed₀  x  Cost of Capital

There are both equity and enterprise approaches to this calculation, in the same way that we have both equity and enterprise approaches to return on capital, valuation multiples and DCF valuation.

Equity approach:  Residual income = Earnings – Equity Capital x Cost of Equity

Enterprise approach:  Residual income = NOPAT – Invested Capital x WACC

In each case it is important that the three components are consistent. For example, WACC should include sources of capital that are reflected in capital employed and NOPAT should only include profit that is derived from the net operating assets funded by that invested capital.

Residual income can be used as a measure of performance that allows for the capital invested in a business. This promotes not just a focus on profit but also on how efficiently that profit is generated in terms of a return on investment. It is for this reason many companies use residual income for their internal reporting instead of (or in addition to) profit.

However, residual income can also form the basis of equity valuation, where value equals capital employed plus the present value of forecast residual income. Again, the precise calculation depends on whether you are valuing directly (an equity approach) or indirectly (an enterprise approach)

Equity value = Equity capital₀ + PV of forecast equity residual income

Enterprise value = Invested capital₀ + PV of forecast enterprise residual income

It is important to remember that residual income valuations are mathematically identical to DCF. This may seem odd given that the above includes the accounting capital (either shareholders’ equity or invested capital) when this does not feature as an input in DCF. However, the accounting capital employed amount does not itself impact value. This is because it features in two places in the valuation – the invested capital addition and the deduction for the capital charge in the residual income component. These partly cancel out leaving just the forecast incremental capital and forecast profit in the final valuation, which combine to equal free cash flow.

If you are interested, click below for the above explanation expressed in mathematical terms.

Residual income valuation and OCI

If your forecast financial statements for a company do not show clean surplus, then using earnings (or NOPAT for an enterprise value approach) in a residual income valuation will produce the wrong answer. This is because the capital charge applied in determining residual income is inconsistent with the difference between profit and cash flow. The present value of the incremental charge for capital due to growth in investment that is included in residual income is not the same as the incremental investment that features in free cash flow.

To obtain a correct valuation it is necessary to include all forecast profit, including gains and losses reported in OCI, when calculating residual income. This is perhaps best explained by considering a specific OCI item – FVOCI equity investments

If an equity investment (not a subsidiary or associate) is accounted for using FVOCI³Under IFRS, companies have an option to account for equity investments (not associates, subsidiaries and investments held for trading) using either fair value through profit and loss (FVPL) or fair value through other comprehensive income (FVOCI). For US GAAP reporters, all gains and losses for equity assets measured at fair value are included in profit and loss., dividend income is reported in earnings but any change in value is reported in OCI. In a forecasting model, the expected return from this asset should be included, which means that investment value in the balance sheet increases each year, with the unrealised gain reported in OCI.

In a residual income valuation, an equity investment affects the calculation in three ways: 

(1) The value of the investment is included in shareholders’ equity and therefore increases the residual income based value by that amount because it is a component of IC₀.

(2) The increase in shareholders’ equity each year (due to the expected investment return) increases the annual capital charge included in forecast annual residual income.

(3) The expected value appreciation (that is reported in OCI) should be part of the profit used to calculate residual income.

Clearly, the value effect of a company owning an equity investment is simply the value of that investment. In a residual income valuation this is fully dealt with by (1) above. This means that (2) and (3) need to offset to zero, but this will only occur if the amount of the expected gain is included in profit. In other words, residual income is based on ‘comprehensive’ income not reported earrings. 

Of course, in an enterprise value based residual income model, these equity investments would be part of the enterprise to equity bridge, and nothing would be included in NOPAT or residual income. 

The full forecast OCI gains and losses should be added to earnings for the equity version of residual income. However, for the enterprise approach, OCI gains and losses should be split into operating and financing components consistent with your definition of EV and IC, in the same way that earnings is split between operating (NOPAT) and financing (the rest of net income). 

Using an enterprise perspective for residual income valuation reduces the relevant number of OCI items because several will produce gains and losses that are solely financing in nature. For example, if a company has significant pension obligations there may be a forecast net gain in OCI due to the higher expected asset return compared with liability interest accretion. However, (assuming the pension funding position is included in EV) this is a financing return and would not be added to NOPAT. The main operating OCI items that could have non-zero forecasts and affect an enterprise based residual income valuation are the recycling of derivative gains and losses arising from some cash flow hedges, and in particular currency translation differences.

Currency translation differences in residual income and DCF valuations

The question from our Footnotes Analyst reader that prompted this article concerned currency translation differences recognised in OCI – specifically, those arising for a company that operates in a significantly weaker currency than that applicable to many of its subsidiaries. The significance of the resulting expected change in exchange rates is such that material currency gains feature in the analyst’s forecast financial statements.

When a company holds a foreign subsidiary that operates in a currency that differs from that of the parent (accountants call this the functional currency), exchange translation differences are recognised in the consolidated financial statements. At each balance sheet date, the foreign subsidiary assets and liabilities are translated into the group reporting currency at the balance sheet date exchange rate (the closing rate). The translation difference arises because the opening balance sheet is retranslated at the closing⁴If companies elect to translate current period profit at the average rate, which is permitted under IFRS, there will be an additional translation difference, but generally it is the balance sheet translation that dominates. rate. Exchange rate changes produce a translation gain or loss that is recognised in OCI⁵This translation difference recognised in OCI should not be confused with foreign exchange gains and losses that arise due to transactions in a foreign currency, such as foreign currency sales purchases that result in FX receivables and payables, and foreign currency borrowings. These transaction exchange differences are recognised in profit, albeit some may be subject to the potential application of hedge accounting..

Considering our analysis above, these forecast translation differences must be included in the calculation of residual income if this is the basis for a residual income valuation.

Remember that for an equity earnings based residual income model it is the full forecast amount recognised in OCI that should be included. However, for the enterprise value based calculation it is only the OCI gains and losses that are ‘operating’ in nature. This means that the currency translation difference would need to be analysed between operating and financing components, although that is easily approximated by simply considering the ratio of net operating assets (invested capital) to equity shareholders’ funds of the foreign subsidiary.

We have prepared a simple interactive model to illustrate. The model should be relatively self-explanatory; however, if you download the model, you will find further explanation about how it works.

Interactive model: Currency translation differences in DCF and residual income valuations

The Footnotes Analyst

You will notice that in our model we compare DCF and residual income based valuations and show that only by including OCI in the residual income calculation do they give the same (and correct) result. The requirement for clean surplus accounting in a forecast model does not apply to a discounted cash flow valuation because (usually) invested capital (or shareholders’ equity) does not feature as a model input. Only if you calculate free cash flow by adjusting profit by the change in invested capital would the clean surplus relationship be relevant. However, in practice free cash flow is generally derived independently of the change in capital.

OCI could still be relevant for a DCF valuation. Most likely, assets and liabilities that produce OCI gains and losses will feature in the enterprise to equity bridge. However, in this case it is the absolute value of these assets and liabilities that matter and not the related gains and losses.

Residual income valuation and non-GAAP performance metrics

If earnings are adjusted to remove certain gains and losses, the resulting non-GAAP metric will not comply with clean surplus. If non-GAAP adjustments affect forecast profit, and this is used in a residual income valuation, the result will be invalid, just as it is when gains and losses are reported in OCI.

Fortunately, many non-GAAP adjustments seen in practice are likely to be forecast at zero in future periods⁶Some common non-GAAP adjustments such as restructuring costs may have non-zero forecasts. It is important that these are not excluded in forecasts used for equity valuation. For more about non-GAAP adjustments see our article ‘Do not use non-GAAP metrics in equity valuation’.. For example, it is common to exclude the business disposal gains and losses from historical non-GAAP performance metrics given their intermittent and volatile nature. However, for forecast financial statements it is unlikely you will anticipate business sales and therefore the non-GAAP adjustment will not be relevant. There is one important exception to this which is intangible asset amortisation.

It is common to exclude amortisation of intangibles arising from a business combination from non-GAAP performance measures and valuation metrics, including NOPAT. This is something we have supported⁷See our article ‘Should you ignore intangible amortisation?’. on the basis that this avoids an element of double counting. However, if the balance sheet value of these intangibles declines in your model due to the amortisation, clean surplus will be violated.

The amortising intangible balance will produce a declining capital charge in your annual forecast residual income, which will increase a residual income based valuation. To counter this effect, you also need to include the amortisation itself in profit (NOPAT). Again, in a DCF valuation no special adjustment is necessary because the amortisation is added back and capital employed is not a direct input in the model.

Insights for investors

• In a residual income valuation, value equals invested capital plus the present value of forecast residual income. Residual income valuations are mathematically equivalent to DCF and must give the same result if computed correctly and based on the same underlying assumptions.

• The profit measure used in a residual income valuation must reflect clean surplus accounting. If you forecast gains and losses that are recognised in OCI, these must be included in residual income.

• Pay particular attention to currency translation differences arising from the translation and consolidation of foreign subsidiaries. Include the full amount in an equity residual income valuation and the ‘operating’ component in the enterprise value version.

• Clean surplus can also be violated if non-GAAP adjustments are made to forecast profit. Intangible amortisation arising from business combinations is a common non-GAAP adjustment that should be included in profit used to derive residual income if using this in a valuation model.

• DCF valuations are not constrained by whether clean surplus accounting is satisfied, assuming free cash flow is calculated directly and without reference to aggregate invested capital.

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