Long Run ROE in Residual Income different, thousands, industry, reading, average

chunty

I am a bit confused. Have read two different idea somewhere in the thousands of pages of reading.

Is the long run ROE assumed to drop to the industry average or to 0 over the long run? I have seen both answers/explanations. Thanks

Uranus08

I wouldn't think ROE going to zero is a situation that makes sense- given that ROE must at least be equal to the cost of capital. As far as I remember the possible situations are RI going to zero, settling at industry standard not ROE



Edited 1 time(s). Last edit at Wednesday, May 25, 2011 at 01:44PM by late_starter.

liquidity

Makes sense. I feel like ive seen questions where it asks what will happen to ROE in the long run, and i remember seeing two answers in different questions - one that if falls to industry average, one to 0. I guess we can say itll fall to industry average, making RI 0 and the price of the stock = to the BV.

neil1234

The best way to think about it is to understand that over time ROE falls to r, so that the present value of future risidual income equals zero and the intrinsic value of the stock = BV of the stock.

chaojimali

I think you might be confusing this because a persistence factor of zero would mean that the ROE drops to the long run industry average straight away. P=1 means it stays at the high level forever and somewhere between 0 and 1 means a gradual decline from high growth ROE to the LR industry average.

I don't have my notes at work so I may be wrong..

ayodayo

Both scenarios are possible and used - it basically depends on the target firm's prospects.

But the most widely used scenario is that ROE drops to industry average as the industry matures, the firm matures and ROE gets closer to (or equal to) r. This is the long run.