Residual Income Valuation:

1. Concept:

Residual Income Valuation (RIV) is a method used to determine the intrinsic value of a company's
stock by evaluating its residual income.

It focuses on economic profits, measuring the excess of actual earnings over the cost of capital.

2. Calculation of Residual Income:

Formula: Residual\ Income = Net\ Income - (Equity\ Cost\ of\ Capital \times Book\ Value\ of\
Equity)Residual Income=Net Income−(Equity Cost of Capital×Book Value of Equity)

Net Income: The actual earnings generated by the company.

Equity Cost of Capital: The expected return for equity investors based on the company's risk and
market conditions.

Book Value of Equity: The shareholders' equity listed on the balance sheet.

3. Steps in Residual Income Valuation:

a. Determine Equity Cost of Capital: Calculate the cost of equity using models like CAPM or other
methods.

b. Forecast Residual Income: Estimate future periods' residual income based on projected net
income, cost of equity, and book value of equity.

c. Calculate Present Value of Residual Income: Discount forecasted residual incomes to their present
value using the cost of equity as the discount rate.

d. Sum Present Values: Add the present values of forecasted residual incomes to derive the intrinsic
value of the company's equity.

4. Advantages:

Focus on Economic Profits: RIV emphasizes wealth creation by considering earnings above the cost of
capital.

Alignment with Shareholder Wealth: It aligns with shareholders' interests by measuring the value
generated for equity investors.

5. Limitations:

Sensitivity to Assumptions: RIV heavily relies on accurate estimation of future earnings and cost of
equity, making it sensitive to changes in these inputs.

Difficulty in Estimation: Forecasting future residual incomes can be challenging, particularly for
companies with volatile earnings or uncertain market conditions.
Not Suitable for Certain Companies: RIV may be less applicable for companies with negative or
inconsistent earnings.

6. Application and Use Cases:

RIV is commonly used in equity valuation, especially by investors seeking to assess a company's
intrinsic value based on its ability to generate economic profits.

It complements other valuation methods, providing an alternative perspective on a company's value.

Conclusion:

The Residual Income Valuation method offers an approach to assess a company's intrinsic value by
focusing on economic profits. While it provides insights into wealth creation for equity investors, its
reliability depends on the accuracy of earnings forecasts and cost of equity estimations. When
applied alongside other valuation methods, it can provide a more comprehensive understanding of a
company's value, aiding investors and analysts in making informed investment decisions.