Residual income valuation

Residual income valuation (RIV; also, residual income model and residual income method, RIM) is an approach to

The cost of equity is typically calculated using the CAPM, although other approaches such as APT are also used. The currency charge to be subtracted is then simply

Equity Charge = Equity Capital x Cost of Equity,

and

Residual income = Net Income − Equity Charge.

Valuation formula

Using the residual income approach, the

today (i.e. at time ${\displaystyle 0}$) and the

${\displaystyle r}$

${\displaystyle V_{0}=BV_{0}+\sum _{t=1}^{\infty }{RI_{t} \over (1+r)^{t}}}$

Here various adjustments to the balance sheet book value may be required;^[1] see Clean surplus accounting.

More typically, the company is assumed to achieve maturity or "constant growth", at time ${\displaystyle m}$, and the below formulae are applied instead. ^[2] (Note that the value will remain identical: the adjustment is a "telescoping" device). In the first step, analysts commonly employ the Perpetuity Growth Model to calculate the terminal value — although various, more formal approaches are also applied ^[3] — which returns:

${\displaystyle T_{m}={RI_{m} \over (r-g)}}$.

In the second step, the RI valuation is then:

${\displaystyle V_{0}=BV_{0}+\sum _{t=1}^{m-1}{RI_{t} \over (1+r)^{t}}+{T_{m} \over (1+r)^{m-1}}}$.

Comparison with other valuation methods

As can be seen, the residual income valuation formula is similar to the dividend discount model (DDM) (and to other discounted cash flow (DCF) valuation models), substituting future residual earnings for dividend (or free cash) payments (and the cost of equity for the weighted average cost of capital).

However, the RI-based approach is most appropriate when a firm is not paying dividends or exhibits an unpredictable dividend pattern, and / or when it has negative free cash flow many years out, but is expected to generate positive cash flow at some point in the future. Further, value is recognized earlier under the RI approach, since a large part of the stock's intrinsic value is recognized immediately – current book value per share – and residual income valuations are thus less sensitive to terminal value.^[4]

At the same time, in addition to the accounting considerations mentioned above, the RI approach will not generally hold if there are expected changes in shares outstanding or if the firm plans to bring in "new" shareholders who derive a net benefit from their capital contributions.^[5]

Although EVA is similar to residual income, there will be technical differences between EVA and RI, specifically

• Enterprise value
• Valuation (finance)#Net asset value method
• Clean surplus accounting
• T-model

Notes

External links and references

Primary references

• Edwards, E. O. & Bell, P. W. (1961). "The Theory and Measurement of Business Income",
  ISBN 0520003764
• Magni, C.A. (2009). "Splitting up value: A critical review of residual income theories". European Journal of Operational Research, 198(1) (October), 1−22.
• Ohlson, J. A. (1995). "Earnings, Book Values and Dividends in Equity Valuation", Contemporary Accounting Research, 11 (Spring), 1995.
• Peasnell, K.V. (1982). "Some Formal Connections Between Economic Values and Yields and Accounting Numbers". Journal of Business Finance and Accounting, Vol.9, No.3, PP. 361–381.

Other references

• Valuing A Company Using The Residual Income Method, Investopedia
• Residual Income Valuation Model, ftsmodules.com
• Three Residual Income Valuation Methods and Discounted Cash Flow Valuation, Pablo Fernandez, University of Navarra – IESE Business School
• Residual Income Valuation: The Problems, James A. Ohlson,
  Stern School of Business, New York University
• A Tutorial on Residual Income Valuation and Value Added Valuation, Kenth Skogsvik, Stockholm School of Economics