Residual Income

Model
1

Residual Income Model

Also known as:
Discounted Abnormal Earnings Model or
Edwards-Bell-Ohlson Model

Commercial implementations
Economic Value Added (EVA) = NOPAT (C% * TC)
Where:
NOPAT = Net Operating Profit After Tax
C% = the cost of capital
TC = total capital

Residual Income Model

Use GAAP to adjust for items and arrive at NOPAT
and TC
Capitalize and amortize R&D (do not expense)
Suspend charge for capital until date for strategic
investments that are not expected to generate an
immediate return
Goodwill is capitalized and not amortized
Deferred taxes are eliminated such that only cash
taxes are treated as an expense.
Add back to capital any inventory LIFO reserve
Operating leases are treated as capital leases and
nonrecurring items are adjusted.
3

Residual Income Model

RI Model analyses the intrinsic value of equity as
the sum of two components:
1. The current book value of equity
2. Present value of expected future residual income

Intrinsic Value of Common Stock:

Residual Income Model

The General Residual Income Model

Do example 5-6

Residual Income Model

Multistage Residual Income Valuation
Continuing Residual Income
Assumptions
1. Residual income continuous indefinitely at a positive
level
2. Residual income is zero from the terminal year forward
3. Residual income decline to zero as ROE reverts to the
cost of equity over time
4. Residual income reflects the reversion of ROE to some
mean levels

Residual Income Model

Multistage Residual Income Valuation
Continuing Residual Income

Residual Income Model

Multistage Residual Income Valuation
Do example 5-8

Residual Income Model

Strengths and weaknesses of residual income
model
Broad guidelines for using a Residual Income
Model