Residual Income (RI) Valuation Model

Introduction

• Residual income reflects net income minus a deduction for the required return on common equity.
• While a firm may show positive earnings, the company would not generate true economic profit in the event that its net profit margin is less than its cost of equity capital.

Basic RIt = Earningst - (rce * Book Value of Equity t-1)

Earnings is EPS when calculating a per share value for RI.

Economic Value Added and Market Value Added (MVA)

• Economic Value Added attempts to quantify the value management created for shareholders during a given period, usually one year.
• This concept was applied in Corporate Finance 1, under capital budgeting topics.

Economic Value Added = NOPAT - $WACC

• NOPAT = [EBIT * (1 - tax rate)]

• $WACC = WACC * invested capital

• When calculating Economic Value Added, the analyst would be expected to make standard adjustments to reported financials, as discussed in FRA part 3.

• MVA is the difference between the market value of a company's long-term debt and equity less the book value of capital supplied by investors.

• MVA attempts to measure the value created by management since the company started.

MVA = MV of debt and equity - book value of supplied capital

Basic RI Model

Share Price0 = BVCE/Share0 + Σ RIt / (1 + rce)t

• This approach starts with the current book value per share of equity today and discounts the expected value of future residual incomes.
• Companies with positive residual incomes should have market share prices that exceed the book value per share.

RI and Dividend Discount Modeling

• RI and DDM tend to produce a similar valuation, however there is a key difference - by starting with the current book value of equity, RI front loads value recognition in a multi-period model.
• Alternatively, a multi-stage DDM model will back load a large portion of value in the terminal value calculation (which is a much less certain value than the current book value).

Fundamental Determinants of RI and the P/B Ratio