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# MOHIT JETHI 15PGP030

## RESIDUAL INCOME VALUATION MODEL

Residual income is the income generated by a firm after accounting for the true cost of its
capital. Residual income valuation (RIV) which is also known as abnormal earnings valuation
model, is an approach to or method of equity valuation which properly accounts for the cost of
equity capital. The word residual refers to any opportunity costs in excess which is measured as
compared to the book value of the shareholders equity and the income that a firm generates after
accounting for the true cost of capital is then the residual income.
This approach is largely similar to the MVA/EVA based approach having similar advantages and
logic. 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
CONCEPT OF RESIDUAL INCOME VALUATION
The basic idea behind this approach is that a rate of return is required by investors from their
resources which are under the management of the firm, provide compensation for their
opportunity cost and account for the level of risk. This rate of return is considered the cost of
equity and a formal equity cost has to be subtracted from net income. Again, for creating
shareholder value, management should be capable of generating returns which is at least equal to
this cost. Therefore, even if the income statement of a company reports a profit, it can be actually
unprofitable economically. Thus, it is possible that a value may be negative in this case, even
though it is positive when traditional DCF approach is applied
CALCULATING RESIDUAL INCOME
Residual Income Calculation and Cost of Capital:-In residual income calculation cost of
capital is used to value stocks. Cost of capital is means cost of debt + cost of equity
Equity Charge = Equity Capital x Cost of Equity
Residual Income = Net Profit (PAT) Cost of Equity
The interest paid by companies on debts are termed as cost of debt. Interest paid by companies
on its debt is indicated in their income statement. But cost of equity is not directly indicated in
financial statements. Cost of equity is important for shareholders. Cost of equity is the cost
incurred by companies to keep shareholders glued to their stocks. By investing in stocks of a
company shareholders takes risk. These shareholders expect to be compensated for the risk they
take. Good companies are very sensitive to this requirement of shareholders. In stock investing,
risk compensation must be done for investors who stay invested for long term. If not them why a
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people will buy stocks? They will be better off by buying a bank deposit or bonds where risk of
loss is negligible. By maintaining a higher cost of equity, companies keep investors interested in
their stocks. Higher cost of capital means ensures more trading of stocks. More trading means
higher volume. Popular stocks has higher trading volume.
A company with higher residual income should be the preferred choice of investors. When two
companies has the same net profit (PAT), choice of investors shall be one with higher residual
income. One of the biggest cost of equity is dividend payment to shareholders. Dividend is paid
on both preference shares and equity shares. Cost of equity component in our formula is related
to total dividend paid + expected return.
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.
FORMULA FOR VALUATION
In residual income approach, a companys stock value can be calculated as sum total of its book
value and its expected future residual incomes present value which is discounted at cost of
equity, the general formula is:

This formula is used when it is assumed that the company will achieve maturity or constant
growth. Here, for calculating the corresponding terminal value, mainly perpetual growth model
is used. The terminal value when it is assumed long run constant growth g from year m is:

## SINGLE STAGE RI MODEL

Value0 = BVE0 + [((ROE rce)/ (rce g)) BVE0]

## Values would be on a per share basis.

Keep in mind that the RI model (like the Gordon Growth Model) can be used to derive a
growth rate, when current and expected share prices are given.

MULTI-STAGE RI MODEL

Just as the dividend discount model and the free cash flow discounting models can have
multiple stages, so can the residual income model.

This requires calculation of a terminal value of the residual income at the end of the
abnormal growth phase.

In contrast to the terminal value in a multi-stage DDM, the terminal value in a multi-stage RI
model will be much smaller, as it will only capture the terminal value of residual income
following the high growth period and not the terminal value of the share price.
In the RI model, much of the value is front-loaded because the model uses the book value of
equity as a starting point.

## ADVANTAGES, DISADVANTAGES AND APPROPRIATENESS OF THE MODEL

ADVANTAGES
o Because terminal value is not as significant in the RI model when compared to
other models, there may be greater certainty in the valuation.
o The model is driven by publicly available accounting data.
o The model is not impacted by near term negative or unpredictable cash flows.
o The model captures economic profit.

DISADVANTAGES
o The model is vulnerable to accounting manipulation by company management.
o The model requires that the analyst have sophisticated understanding of public
financial reporting, as large adjustments to report financials may be required.

APPROPRIATENESS
o The RI model can be utilized when: the company does not pay dividends; free
cash flows are expected to be negative; or when there exists a high level of
uncertainty around the terminal value.
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. 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. 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.