Hi everyone,

I know when calculating the WACC for a DCF model usually the cost of equity (in %) is multiplied with the market value of equity, not the book value, right?
But when valuing a stock with the residual income model, usually the cost of equity (in %) is multiplied with the book value of equity. Here is the equation for the residual income model (same as in the image)...

Value (today) = Book Value (totay) + (Earnings for period 1 - (cost of equity x book value of equity)

Can you please tell me, why we use book value of equity here instead of market value, which I think makes more sense?
Thank you!

Best Response

Residual income model just uses book value as a starting point. If the stock's ROE is the same as its cost of equity, then it is worth 1x book value. If ROE exceeds cost of equity then it is worth more than 1x, vice versa if ROE is lower.

So in the formula you posted the r*B is sort of like an imaginary interest payment - it's the cost of using equity capital to generate those earnings.

You don't use market value of equity because that's a measure of what other people think the stock is worth - by using residual income model or DCF you're trying to figure out an intrinsic value.

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