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Valuing A Company Using The Residual Income Method By Investopedia Staff
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There are many different methods to valuing a company or its stock. One could opt to use a relative valuation approach, comparing multiples and metrics of a firm in relation to other companies within its industry or sector. Another alternative would be value a firm based upon an absolute estimate, such as implementing discounted cash flow modeling or the dividend discount method, in an attempt to place an intrinsic value to said firm. One absolute valuation method which may not be so familiar to most, but is widely used by analysts is the residual income method. In this article we will introduce you to the underlying basics behind the residual income model and how it can be used to place an absolute value on a firm. (The DDM is one of the most foundational of financial theories, but it's only as good as its assumptions. Check out Digging Into The Dividend Discount Model.)
TUTORIAL: Top Stock-Picking Strategies
An Introduction to Residual Income
When most hear the term residual income, they think of excess cash or disposable income. Although that definition is correct in the scope of personal finance, in terms of equity valuation residual income is the income generated by a firm after accounting for the true cost of its capital. You might be asking, "but don't companies already account for their cost of capital in their interest expense?" Yes and no. Interest expense on the income statement only accounts for a firm's cost of its debt, ignoring its cost of equity, such as dividends payouts and other equity costs. Looking at the cost of equity another way, think of it as the shareholders' opportunity cost, or the required rate of return. The residual income model attempts to adjust a firm's future earnings estimates, to compensate for the equity cost and place a more accurate value to a firm. Although the return to equity holders is not a legal requirement like the return to bondholders, in order to attract investors firms must compensate them for the investment risk exposure.
In calculating a firm's residual income the key calculation is to determine its equity charge. Equity charge is simply a firm's total equity capital multiplied by the required rate of return of that equity, can be estimated using the capital asset pricing model. The formula below shows the equity charge equation.
Equity Charge = Equity Capital x Cost of Equity
Once we have calculated the equity charge, we only have to subtract it from the firm's net income to come up its residual income. For example, if Company X reported earnings of $100,000 last year and financed its capital structure with $950,000 worth of equity at a required rate of return of 11%, its residual income would be:
Equity Charge $950,000 x 0.11 = $104,500
Net Income $100,000
Equity Charge -$104,500
Residual Income -$4,500
So as you can see from the above example, using the concept of residual income, although Company X is reporting a profit on its income statement (which it should), once its cost of equity is included in relation to its return to shareholders, it is actually economically unprofitable based on the given level of risk. This finding is the primary driver behind the use of the residual income method. A scenario where a company is profitable on an accounting basis, it may still not be a profitable venture from a shareholder's perspective if it cannot generate residual income.
Intrinsic Value With Residual Income
Now that we've found how to compute residual income, we must now use this information to formulate a true value estimate for a firm. Like other absolute valuation approaches, the concept of discounting future earnings is put to use in residual income modeling as well. The intrinsic, or fair value, of a company's stock using a the residual income approach can be broken down into its book value and the present values of its expected future residual incomes, as illustrated in the formula below.
As you may have noticed, the residual income valuation formula is very similar to a multistage dividend discount model, substituting future dividend payments for future residual earnings. Using the same basic principles as a dividend discount model to calculate future residual earnings, we can derive an intrinsic value for a firm's stock. In contrast to the DCF approach which uses the weighted average cost of capital for the discount rate, the appropriate rate for the residual income strategy is the cost of equity. (Learn the strengths and weaknesses of passive and active management when trying to uncover the overall market's worth. Check out Strategies For Determining The Market's True Worth.)
The Bottom Line
The residual income approach offers both positives and negatives when compared to the more often used dividend discount and DCF methods. On the plus side, residual income models make use of data readily available from a firm's financial statements and can be used well with firms who do not pay dividends or do not generate positive free cash flow. Most importantly, as we discussed earlier, residual income models look at the economic profitability of a firm rather than just its accounting profitability. The biggest drawback of the residual income method is the fact that it relies so heavily on forward looking estimates of a firm's financial statements, leaving forecasts vulnerable to psychological biases or historic misrepresentation of a firms financial statements.
All that being said, the residual income valuation approach is a viable and increasingly popular method of valuation and can be implemented rather easily by even novice investors. When used alongside the other popular valuation approaches, residual income valuation can give you a clearer estimate of what the true intrinsic value of a firm may be. (Don't be overwhelmed by the many valuation techniques out there - knowing a few characteristics about a company will help you pick the best one. See How To Choose The Best Stock Valuation Method.)
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Is residual income considered profit?
Understand what residual income is and under what circumstances it may be considered profit. Learn how this can benefit personal ... Read Answer >>
What is the best app to track my residual income?
Learn about apps that help you manage and track your residual income whether you have complex portfolios with multiple investments ... Read Answer >>
What is the difference between terminal value and residual value?
Read a brief overview of residual value and terminal value, two near-identical terms that refer to the future value of a ... Read Answer >>
When can I use the Dividend Discount Method (DDM) to value a stock?
Learn about the dividend discount model and when it can most appropriately be used to measure the value of a stock by fundamental ... Read Answer >>
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Work With Investopedia
About Us Advertise With Us Contact Us Careers
© 2017, Investopedia, LLC. Feedback All Rights Reserved Terms Of Use Privacy Policy
Unmute/
There are many different methods to valuing a company or its stock. One could opt to use a relative valuation approach, comparing multiples and metrics of a firm in relation to other companies within its industry or sector. Another alternative would be value a firm based upon an absolute estimate, such as implementing discounted cash flow modeling or the dividend discount method, in an attempt to place an intrinsic value to said firm. One absolute valuation method which may not be so familiar to most, but is widely used by analysts is the residual income method. In this article we will introduce you to the underlying basics behind the residual income model and how it can be used to place an absolute value on a firm. (The DDM is one of the most foundational of financial theories, but it's only as good as its assumptions. Check out Digging Into The Dividend Discount Model.)
TUTORIAL: Top Stock-Picking Strategies
An Introduction to Residual Income
When most hear the term residual income, they think of excess cash or disposable income. Although that definition is correct in the scope of personal finance, in terms of equity valuation residual income is the income generated by a firm after accounting for the true cost of its capital. You might be asking, "but don't companies already account for their cost of capital in their interest expense?" Yes and no. Interest expense on the income statement only accounts for a firm's cost of its debt, ignoring its cost of equity, such as dividends payouts and other equity costs. Looking at the cost of equity another way, think of it as the shareholders' opportunity cost, or the required rate of return. The residual income model attempts to adjust a firm's future earnings estimates, to compensate for the equity cost and place a more accurate value to a firm. Although the return to equity holders is not a legal requirement like the return to bondholders, in order to attract investors firms must compensate them for the investment risk exposure.
In calculating a firm's residual income the key calculation is to determine its equity charge. Equity charge is simply a firm's total equity capital multiplied by the required rate of return of that equity, can be estimated using the capital asset pricing model. The formula below shows the equity charge equation.
Equity Charge = Equity Capital x Cost of Equity
Once we have calculated the equity charge, we only have to subtract it from the firm's net income to come up its residual income. For example, if Company X reported earnings of $100,000 last year and financed its capital structure with $950,000 worth of equity at a required rate of return of 11%, its residual income would be:
Equity Charge $950,000 x 0.11 = $104,500
Net Income $100,000
Equity Charge -$104,500
Residual Income -$4,500
So as you can see from the above example, using the concept of residual income, although Company X is reporting a profit on its income statement (which it should), once its cost of equity is included in relation to its return to shareholders, it is actually economically unprofitable based on the given level of risk. This finding is the primary driver behind the use of the residual income method. A scenario where a company is profitable on an accounting basis, it may still not be a profitable venture from a shareholder's perspective if it cannot generate residual income.
Intrinsic Value With Residual Income
Now that we've found how to compute residual income, we must now use this information to formulate a true value estimate for a firm. Like other absolute valuation approaches, the concept of discounting future earnings is put to use in residual income modeling as well. The intrinsic, or fair value, of a company's stock using a the residual income approach can be broken down into its book value and the present values of its expected future residual incomes, as illustrated in the formula below.
As you may have noticed, the residual income valuation formula is very similar to a multistage dividend discount model, substituting future dividend payments for future residual earnings. Using the same basic principles as a dividend discount model to calculate future residual earnings, we can derive an intrinsic value for a firm's stock. In contrast to the DCF approach which uses the weighted average cost of capital for the discount rate, the appropriate rate for the residual income strategy is the cost of equity. (Learn the strengths and weaknesses of passive and active management when trying to uncover the overall market's worth. Check out Strategies For Determining The Market's True Worth.)
The Bottom Line
The residual income approach offers both positives and negatives when compared to the more often used dividend discount and DCF methods. On the plus side, residual income models make use of data readily available from a firm's financial statements and can be used well with firms who do not pay dividends or do not generate positive free cash flow. Most importantly, as we discussed earlier, residual income models look at the economic profitability of a firm rather than just its accounting profitability. The biggest drawback of the residual income method is the fact that it relies so heavily on forward looking estimates of a firm's financial statements, leaving forecasts vulnerable to psychological biases or historic misrepresentation of a firms financial statements.
All that being said, the residual income valuation approach is a viable and increasingly popular method of valuation and can be implemented rather easily by even novice investors. When used alongside the other popular valuation approaches, residual income valuation can give you a clearer estimate of what the true intrinsic value of a firm may be. (Don't be overwhelmed by the many valuation techniques out there - knowing a few characteristics about a company will help you pick the best one. See How To Choose The Best Stock Valuation Method.)
Related Articles
Financial Advisor
Active Risk vs. Residual Risk: Differences and Examples
Active risk and residual risk are common risk measurements in portfolio management. This article discusses them, their calculations and their main differences.
Investing
How And Why Do Companies Pay Dividends?
The arguments for dividends include the idea that a dividend provides certainty about a company’s well being.
Investing
How to Choose the Best Stock Valuation Method
Don't be overwhelmed by the many valuation techniques out there - knowing a few characteristics about a company will help you pick the best one.
Investing
How To Choose The Best Stock Valuation Method
There is no single valuation tactic that works in every situation. But a company’s characteristics provide clues to investors about the best method to use.
Investing
What Is The Intrinsic Value Of A Stock?
Intrinsic value can be subjective and difficult to estimate. It’s a perception of a security’s value that factors tangible and intangible factors.
Investing
Learn The Lingo Of Private Equity Investing
Because of the non-public nature of private equity, it can be difficult to the learn the lingo. We break it down here.
Investing
How to Value a Real Estate Investment Property
Make sure you know what your real estate investment is worth before you sign the ownership papers.
Personal Finance
DCF Vs. Comparables: Which One To Use
DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
Investing
Discounted Cash Flow (DCF)
Discover how investors can use this valuation method to determine the intrinsic value of a stock.
Investing
Quantifying the Growth Implied by Snap's Valuation
Based on an intrinsic valuation model, what is the growth rate implied by Snap's current price?
RELATED FAQS
Is residual income considered profit?
Understand what residual income is and under what circumstances it may be considered profit. Learn how this can benefit personal ... Read Answer >>
What is the best app to track my residual income?
Learn about apps that help you manage and track your residual income whether you have complex portfolios with multiple investments ... Read Answer >>
What is the difference between terminal value and residual value?
Read a brief overview of residual value and terminal value, two near-identical terms that refer to the future value of a ... Read Answer >>
When can I use the Dividend Discount Method (DDM) to value a stock?
Learn about the dividend discount model and when it can most appropriately be used to measure the value of a stock by fundamental ... Read Answer >>
Trending
Securing Your Future
7 Battered Stocks Set to Rebound in 2018
Tesla Is Biggest Short in North America
Trump's Tax Reform Plan
Announcing the Top 100 Most Influential Financial Advisors
Hot Definitions
Residual Value
Minority Interest
Target Hash
Payout Ratio
Terminal Value - TV
Run Rate
Work With Investopedia
About Us Advertise With Us Contact Us Careers
© 2017, Investopedia, LLC. Feedback All Rights Reserved Terms Of Use Privacy Policy
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