Residual income valuation
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Residual income valuation (RIV; also, residual income ''model'' and residual income ''method'', RIM) is an approach to
equity valuation In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit fr ...
that formally accounts for the
cost of equity In finance, the cost of equity is the return (often expressed as a rate of return) a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their capital. Firms need to acquire cap ...
capital. Here, "residual" means in excess of any
opportunity cost In microeconomic theory, the opportunity cost of a particular activity is the value or benefit given up by engaging in that activity, relative to engaging in an alternative activity. More effective it means if you chose one activity (for example ...
s 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 new ...
. 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 t ...
/ 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 In finance, return is a profit on an investment. It comprises any change in value of the investment, and/or cash flows (or securities, or other investments) which the investor receives from that investment, such as interest payments, coupons, ca ...
from their resources – i.e.
equity Equity may refer to: Finance, accounting and ownership * Equity (finance), ownership of assets that have liabilities attached to them ** Stock, equity based on original contributions of cash or other value to a business ** Home equity, the dif ...
– under the control of the firm's management, compensating them for their
opportunity cost In microeconomic theory, the opportunity cost of a particular activity is the value or benefit given up by engaging in that activity, relative to engaging in an alternative activity. More effective it means if you chose one activity (for example ...
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 i ...
. It is thus possible that a value deemed positive using a traditional
discounted cash flow The discounted cash flow (DCF) analysis is a method in finance of valuing a security, project, company, or asset using the concepts of the time value of money. Discounted cash flow analysis is widely used in investment finance, real estate devel ...
(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 ...
to more traditional techniques.


Calculation of residual income

The cost of equity is typically calculated using the
CAPM CAPM may refer to: * Capital asset pricing model, a fundamental model in finance * Certified Associate in Project Management, an entry-level credential for project managers {{Disambig ...
, 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. Tra ...
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 The clean surplus accounting method provides elements of a forecasting model that yields price as a function of earnings, expected returns, and change in book value. Ohlson, J. A. (1995)"Earnings, Book Values and Dividends in Equity Valuation" Con ...
. 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 In finance and investing, the dividend discount model (DDM) is a method of valuing the price of a company's stock based on the fact that its stock is worth the sum of all of its future dividend payments, discounted back to their present value. In ot ...
(DDM) (and to other
discounted cash flow The discounted cash flow (DCF) analysis is a method in finance of valuing a security, project, company, or asset using the concepts of the time value of money. Discounted cash flow analysis is widely used in investment finance, real estate devel ...
(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 The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital. Importantly, it is dictated by ...
). 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 The stern is the back or aft-most part of a ship or boat, technically defined as the area built up over the sternpost, extending upwards from the counter rail to the taffrail. The stern lies opposite the bow, the foremost part of a ship. Orig ...
, 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 .


See also

*
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 The clean surplus accounting method provides elements of a forecasting model that yields price as a function of earnings, expected returns, and change in book value. Ohlson, J. A. (1995)"Earnings, Book Values and Dividends in Equity Valuation" Con ...
* T-model


Notes


External links and references


Primary references

*Edwards, E. O. & Bell, P. W. (1961). "The Theory and Measurement of Business Income",
University of California Press The University of California Press, otherwise known as UC Press, is a publishing house associated with the University of California that engages in academic publishing. It was founded in 1893 to publish scholarly and scientific works by faculty ...
, 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 ''Contemporary Accounting Research'' is a peer-reviewed academic journal covering research on all aspects of accounting's role within organizations, markets, or society. The journal publishes articles in all areas of accounting, (including audit, ...
, 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 ha ...

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 Eliz ...
IESE Business School IESE Business School is the graduate business school of the University of Navarra. Founded in 1958 in Barcelona where its main campus is located,López, T. & Pampliega, J“La fundación del IESE (1956–1958)” Universidad de Navarra, Bibliotec ...

Residual Income Valuation: The Problems
James A. Ohlson,
Stern School of Business The New York University Leonard N. Stern School of Business (commonly referred to as NYU Stern, The Stern School of Business, or simply Stern) is the business school of New York University, a private research university based in New York City. I ...
,
New York University New York University (NYU) is a private research university in New York City. Chartered in 1831 by the New York State Legislature, NYU was founded by a group of New Yorkers led by then-Secretary of the Treasury Albert Gallatin. In 1832, the ...

A Tutorial on Residual Income Valuation and Value Added Valuation
Kenth Skogsvik,
Stockholm School of Economics The Stockholm School of Economics (SSE; sv, Handelshögskolan i Stockholm, HHS) is a private business school located in city district Vasastaden in the central part of Stockholm, Sweden. SSE offers BSc, MSc and MBA programs, along with ...
{{corporate finance and investment banking Valuation (finance) Fundamental analysis