Residual Income Model

Under the discounted cash flows model, firm values are present values of all future dividends.
Let MVE be the market value of equity (firm value):

𝐷𝐷1 𝐷𝐷2 𝐷𝐷∞

𝑀𝑀𝑀𝑀𝑀𝑀0 = + +⋯+
(1 + 𝑘𝑘𝑒𝑒 ) (1 + 𝑘𝑘𝑒𝑒 )2 (1 + 𝑘𝑘𝑒𝑒 )∞
(1)

Let BVE be the book value of equity (equity value as recorded in balance sheet). We know
that:
𝐵𝐵𝐵𝐵𝐵𝐵1 = 𝐵𝐵𝐵𝐵𝐵𝐵0 + 𝑁𝑁𝑁𝑁1 − 𝐷𝐷1

where NI = Net income. Rearranging, we get:

𝐷𝐷1 = 𝑁𝑁𝑁𝑁1 + 𝐵𝐵𝐵𝐵𝐵𝐵0 − 𝐵𝐵𝐵𝐵𝐵𝐵1
𝐷𝐷2 = 𝑁𝑁𝑁𝑁2 + 𝐵𝐵𝐵𝐵𝐵𝐵1 − 𝐵𝐵𝐵𝐵𝐵𝐵2
⋮
etc
(2)
Residual Income Model

Substituting equation (2) into (1), we arrived at the residual income model:

𝑁𝑁𝑁𝑁1 − 𝑘𝑘𝑒𝑒 × 𝐵𝐵𝐵𝐵𝐵𝐵0 𝑁𝑁𝑁𝑁2 − 𝑘𝑘𝑒𝑒 × 𝐵𝐵𝐵𝐵𝐵𝐵1

𝑀𝑀𝑀𝑀𝑀𝑀0 = 𝐵𝐵𝐵𝐵𝐵𝐵0 + + +⋯
(1 + 𝑘𝑘𝑒𝑒 ) (1 + 𝑘𝑘𝑒𝑒 )2

Note that the expected return of equity ke can be determined using CAPM:

𝑘𝑘𝑒𝑒 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽(𝑅𝑅𝑚𝑚 − 𝑅𝑅𝑓𝑓 )

Hence, (ke x BVE0) is the expected earning of year 1 and

NI1 is the actual earning reported in year 1.

The difference between actual and expected earnings is called the residual income (RI) or
abnormal earning. Thus the residual income model can be summarized as:

𝑴𝑴𝑴𝑴𝑴𝑴𝟎𝟎 = 𝑩𝑩𝑩𝑩𝑩𝑩𝟎𝟎 + 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽 𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐 𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇𝒇 𝑹𝑹𝑹𝑹𝑹𝑹

Note: You do not need to know how to derive the residual income model.
Spreadsheet illustration – Residual Income Model