TheInfoList

OR:

Residual income valuation (RIV; also, residual income ''model'' and residual income ''method'', RIM) is an approach to equity valuation that formally accounts for the cost of equity capital. Here, "residual" means in excess of any opportunity costs measured relative to the book value of
shareholders' equity In finance, equity is ownership of assets that may have debts or other liabilities attached to them. Equity is measured for accounting purposes by subtracting liabilities from the value of the assets. For example, if someone owns a car worth \$2 ...
; residual income (RI) is then the income generated by a firm after accounting for the true
cost of capital In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate ne ...
. The approach is largely analogous to the
EVA Eva or EVA may refer to: * Eva (name), a feminine given name Arts, entertainment, and media Fictional characters * Eva (Dynamite Entertainment), a comic book character by Dynamite Entertainment * Eva (''Devil May Cry''), Dante's mother in ...
/ MVA based approach, with similar logic and advantages. Residual Income valuation has its origins in Edwards & Bell (1961), Peasnell (1982), and Ohlson (1995).

# Concept

The underlying idea is that investors require a rate of return from their resources – i.e. equity – under the control of the firm's management, compensating them for their opportunity cost and accounting for the level of risk resulting. This rate of return is the cost of equity, and a formal equity cost must be subtracted from net income. Consequently, to create
shareholder value Shareholder value is a business term, sometimes phrased as shareholder value maximization. It became prominent during the 1980s and 1990s along with the management principle value-based management or "managing for value". Definition The term "shar ...
, management must generate returns at least as great as this cost. Thus, although a company may report a profit on its income statement, it may actually be economically unprofitable; see
Economic profit In economics, profit is the difference between the revenue that an economic entity has received from its outputs and the total cost of its inputs. It is equal to total revenue minus total cost, including both explicit and implicit costs. It ...
. It is thus possible that a value deemed positive using a traditional discounted cash flow (DCF) approach may be negative here. RI-based valuation is therefore a valuable
complement A complement is something that completes something else. Complement may refer specifically to: The arts * Complement (music), an interval that, when added to another, spans an octave ** Aggregate complementation, the separation of pitch-clas ...

# Calculation of residual income

The cost of equity is typically calculated using the CAPM, although other approaches such as
APT Apt. is an abbreviation for apartment. Apt may also refer to: Places * Apt Cathedral, a former cathedral, and national monument of France, in the town of Apt in Provence * Apt, Vaucluse, a commune of the Vaucluse département of France * A ...
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 value of a company's stock can be calculated as the sum of its
book value In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. T ...
and the
present value In economics and finance, present value (PV), also known as present discounted value, is the value of an expected income stream determined as of the date of valuation. The present value is usually less than the future value because money has inte ...
of its expected future residual income, discounted at the cost of equity, $r$, resulting in the general formula: :$V_0 = BV_0 + \sum_^$ Here various adjustments to the
balance sheet In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business ...
book value may be required; see Clean surplus accounting. Typically, the above formula will be applied such that the company is assumed to achieve maturity, or "constant growth". (Note that the value will remain identical: the adjustment is a "telescoping" device). Here, analysts commonly employ the Perpetuity Growth Model to calculate the corresponding terminal value (although various, more formal approaches are also applied). Then, assuming long-run, "constant", growth $g$ from year $m$, the terminal value is :$T_ =$, and the RI valuation would then be: :$V_0 = BV_0 + \sum_^ +$.

# 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. 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. Although EVA is similar to residual income, there will be technical differences between EVA and RI, specifically Stern Stewart & Co, originators of EVA, recommend a fairly large number of adjustments to
NOPAT In corporate finance, net operating profit after tax (NOPAT) is a company's after- tax operating profit for all investors, including shareholders and debt holders.Moneyterms.co.ukNOPAT/ref> NOPAT is used by analysts and investors as a precise and ...
before the methodology may be applied. See .

*
Enterprise value Enterprise value (EV), total enterprise value (TEV), or firm value (FV) is an economic measure reflecting the market value of a business (i.e. as distinct from market price). It is a sum of claims by all claimants: creditors (secured and unsecured) ...
* Valuation (finance)#Net asset value method * Clean surplus accounting * T-model

# Notes

## Primary references

*Edwards, E. O. & Bell, P. W. (1961). "The Theory and Measurement of Business Income", University of California Press, Berkeley and Los Angeles, 1961. *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 Investopedia is a financial media website headquartered in New York City. Founded in 1999, Investopedia provides investment dictionaries, advice, reviews, ratings, and comparisons of financial products such as securities accounts. Investopedia ...

Residual Income Valuation Model
ftsmodules.com
Three Residual Income Valuation Methods and Discounted Cash Flow Valuation
Pablo Fernandez,
University of Navarra , image = UNAV.svg , latin_name = Universitas Studiorum Navarrensis , established = 17 October 1952 , type = Private, Roman Catholic , chancellor = Fernando Ocáriz Braña , president = María Iraburu Eli ...