Residual Income Model

Residual Income
Residual income is net income less a charge
(deduction) for common shareholders
opportunity cost in generating net income.

It is the residual or remaining income after

considering the costs of a companys equity
capital.

Some other names of residual income are

economic profit, abnormal earnings and
Economic Value Added
 Residual Income Model
Residual income can be used to measure internal
corporate performance and to determine the intrinsic
value of common stock

The residual income model of valuation analyzes the

intrinsic value of equity as the sum of two
components:

The current book value of equity

The present value of expected future residual income
 Residual Income Model

RI t
Et kBt 1
V0 B0 B0
t 1 (1 k ) t
t 1 (1 k ) t

Where
V0 = value of a share of stock today
B0 = current per-share book value of equity
Bt = expected per-share book value of equity at time t
k = required rate of return on equity investment (cost of
equity)
Et = expected EPS for period t
RIt = expected per-share residual income, equal to Et-rBt-1
Example Residual Income Model:
Year 1 2 3
Beginning book-value per share (Bt-1) 6.00 7.00 8.25
Net income per share (EPS) 2.00 2.50 4.00
Less: dividend per share 1.00 1.25 12.25
------- -------- --------
Change in retained earnings (EPS-D) 1.00 1.25 -8.25
------- -------- ---------
Ending book value per-share (Bt-1+EPS-D) 7.00 8.25 0.00
Net income per share (EPS) 2.00 2.50 4.00
Less per share equity charge (rBt-1), r=0.10 0.60 0.70 0.825
------- ------- --------
Residual income (EPS-equity charge) 1.40 1.80 3.175
The value using residual income model is:

1.40 1.80 3.175

V0 6.00 2

1.10 (1.10) (1.10)3
6.00 1.2727 1.4876 2.3854
11.15

The value using a discounted dividend approach is:

1.00 1.25 12.25

V0 2

1.10 (1.10) (1.10)3
0.9091 1.0331 9.2036
11.15
 RI Model Vs DDM
The example shows that the RI model is fundamentally
similar to other valuation models , such as the DDM, and
given consistent assumptions will yield equivalent
results.
However, recognition of value typically occurs earlier in
RI models than in DDM.
The RI model attributes 6.00 of the 11.15 total value to
the first period. DDM attributes 9.2036 of the total value
to the final time period.
This property of RI models make the valuations less
sensitive to terminal value estimates in multi-stage
growth models.
 RI Model and Clean Surplus
The RI model assumes clean surplus
accounting.
The clean surplus accounting assumption is
that ending book value per share is equal to
beginning book value plus net income minus
dividends.
Ownership transactions do not affect the book
value.
Fundamental Determinants of Residual
Income
P0 ROE g

Bo kg
P0 ROE k
1
Bo kg

ROE k
P0 B0 B0
kg
The residual income model is most closely
related to the P/B ratio.

A stocks justified P/B ratio is directly related to

expected future residual income.
 Strengths of RI Model
Terminal values do not make up a large portion of the total
present value relative to other models.

They use readily available accounting data.

The models can be readily applied to companies that do not

pay dividends or to companies that do not have expected
near-term free cash flows.

The models can be used when cash flows are unpredictable.

The models have an appealing focus on economic profitability.

 Weaknesses of RI Model
The models are based on accounting data that can be subject
to manipulation by management.

Accounting data used as inputs may require significant

adjustments to hold the clean surplus assumption.
 When to Use RI Model
A residual income model is most appropriate
when
a company does not pay dividends, or its
dividends are not predictable;
a company's expected free cash flows are
negative within the analyst's comfortable forecast
horizon; or
there is great uncertainty in forecasting terminal
values using an alternative present value
approach.
 When not to Use RI Model
Residual income models are least appropriate
when
there are significant departures from clean
surplus accounting; or
significant determinants of residual income,
such as book value and ROE, are not
predictable.