Residual Income Valuation
A method for valuing a business, security, or financial asset by determining the residual income it generates.
What Is Residual Income Valuation?
Residual Income Valuation is a method for valuing a business, security, or financial asset by determining the residual income it generates.
Residual income is essentially the income that remains after deducting the cost of capital or other charges from a firm's net income. It represents the excess profit after covering all relevant costs of doing business and financing the employed capital.
The word "residual" generally means a remainder left after a portion is taken out of a certain item or value. The income/net income means the amount remaining once the direct and indirect expenses are deducted from the firm's revenues. The income here can be net income or even operating income.
An organization/firm can be valued through different valuation methods. For example, analysts or stakeholders can utilize multiple metrics and approaches against other companies and their stocks for comparison. These kinds of evaluations are known as "Relative Valuations."
Another method compasses using accurate and absolute estimates by valuing the firm using discounted cash flow (DCF) modeling or the dividend discount model to assess the intrinsic value of the firm or even their stock.
These calculations are known as "Absolute Valuations."
Among these absolute valuations, the Residual Income Valuation method can be used by analysts. The result is a dollar amount that gives an absolute term to decide.
Key Takeaways
- Residual Income Valuation is a method for valuing a business, security, or financial asset by determining the residual income it generates.
- Residual income is the amount that remains after deducting direct and indirect expenses from a firm's revenues, which can be either net income or operating income.
- Residual Income Valuation is a method to estimate the value of a business or its stock based on the present value of future residual incomes discounted at the appropriate cost of equity.
- Residual income is compared to a minimum rate of return, and if it exceeds this threshold, an investment project is approved. It helps in making investment decisions and performance evaluation.
Analysis of Residual Income Valuation
In theory, residual income is the amount above a certain threshold the management sets. This certain threshold can be a minimum rate of return, an imputed charge on investment, or an equity charge.
A minimum required rate of return is the threshold the firm has to maintain not to dilute its income and rate of return that might make the firm unprofitable or undesirable.
If an investment earns above the threshold established by the minimum rate of return assigned to the investment, the project can be approved. Or else the capital investment will be rejected.
Another use of Residual Income Valuation is to estimate the value of a business. This estimation will help the management make investment decisions. It can also serve the purpose of performance valuation.
So, it's the responsibility of the management and project managers to search, identify and recommend the projects that may help the firm realize the returns that are most optimal for the organization.
In another iteration, residual income valuation is a method used to value equity based on the assumption that the value of a company's stock shall equal the PV of future residual incomes discounted at the appropriate cost of equity.
Capital is a scarce resource, and it should be invested with the utmost care, and priority should be made to optimize the returns on such investments. The management should carefully assess the opportunities in terms of monetary and qualitative aspects.
Such investments should not limit the organization, nor should they deplete the capital resources. This income shows the leftover currency amount after the interest charge on the equity or assets of the organization, which could be classified as surplus.
Residual Income Valuation Model Examples
Residual income calculations are quite easy, simple, and straightforward. Substituting the numbers in the formula can help us to find the end product.
The valuation takes a different turn when the cost of equity comes in. For assessing the cost of equity, there are different procedures.
For the sake of simplicity, the calculation of the cost of equity is omitted here.
Scenario 1
Let's say, Return on Investment is 15% on the invested capital of $1M. So, that's $150,000 in absolute terms, with the minimum required rate of return of 10% on the amount of capital invested.
So, the ROI on the investment in dollar amount is $150,000, and the required rate of return in dollar amount is $100,000. The residual income is $50,000. That is in excess of the minimum return required on the investment.
In other words, residual income is the excess of funds over the difference between the ROI and required ROR.
= $150,000 - $100,000 = $50,000
The required rate of return is derived from the WACC, which is adjusted for the riskiness of the potential investment. In performance measures, residual income makes the managers aim for the dollar amount instead of the ROI; that's just a percentage.
A capital charge or an imputed cost of investment is defined as the required rate of return times the business unit's assets. This is to set the level to realize at least the required return on the asset invested in the business.
Scenario 2
If,
Residual Income = Operating Income - The imputed cost of investment
The operating income was $500,000, total assets were $2M, and the required return rate was 12%. Then the residual income would be $260,000, which is in excess of the imputed cost of $240,000.
= $500,000 - ($2,000,000 x 12%) = $500,000 - $240,000 = $260,000.
The above definitions and uses are most beneficial in personal finance. But, when we talk about equity and equity valuation, residual income is the income generated to match and account for the cost of capital or exceed it.
The main underlying assumption is to account for the true cost of capital by the income generated by the firm. The true cost of capital includes the cost of equity, debt, and preference shares.
The net income does account for the interest expense, adjusting it for the cost of debt. But, it's not adjusted for the cost of equity since net income doesn't account for the dividend payments or other equity distributions.
We can conclude that the residual income is the company's income adjusted for the cost of equity. Remember that the equity cost is the required return rate asked by investors as payment for the opportunity cost and level of risk.
Thus, the value of a company calculated using the Residual Income Valuation is generally more accurate since it is based on the economic profits of a company.
The equity charge is equity capital times the cost of equity. The CAPM model can be used to ascertain the cost of equity. An equity charge is a firm's total equity capital multiplied by that equity's required rate of return.
In the context of the equity valuation residual income, the residual income would be,
Residual income = OI - Equity Charge.
This can also be put as
Residual income = OI - (Equity Capital x Cost of Equity)
Value of equity = Book value of equity + (Sum of the expected residual incomes in perpetuity discounted at the cost of equity capital employed in the company)
Scenario 3
| Net Income | $120,000 |
|---|---|
| Equity Capital | $950,000 |
| Cost Of Equity | 11% |
Calculations will be like,
= $120,000 - ($950,000 x 11%)
= $120,000 - $104,500 = $15,500
This can be interpreted as an excess of OI over the equity charge. As a result, the organization is profitable on the income statement and economically profitable since the OI also covers the equity charge.
If the cost of equity is increased to 15%, then the organization will have a negative residual income even though the organization is profitable on paper.
The residual income in this scenario will be a negative $22,500. Since the equity charge will $950,000 times 15% that equals to $142,5000.
Residual Income Valuation Benefits and Limitations
Despite being a heavily used method in valuation. The residual income valuation method is not immune to the limitations of the package. There are benefits followed by some limitations.
Some of the benefits are:
- It's suitable for grown, stable, and mature companies to use Residual Income Valuation. The companies that don't give out dividends to their shareholders.
- The firm can also use its alternative, the Discounted Dividend Model (DDM), for dividend payments and their calculations.
- The analysts and information users should be aware that the approach is based on forecasted assumptions and prone to manipulations and biases. Better suited for companies that don't have positive cash flows yet.
- This valuation is an absolute valuation model used to calculate and assess the organization's intrinsic value. It's one of the most reliable and used methods in investment research.
- The calculations are executed with the information readily available in the financial statements. Therefore, no other statements or calculations aren't required.
On the other hand, the limitations are:
- The biggest limitation of the residual income method is that it relies on projected estimates of a firm's financial statements.
- It leaves forecasts vulnerable to psychological biases or historical misrepresentations of a firm's financial statements.
- It's a common understanding that net income or operating income are incomes based on an accrual basis. And cash and cash flows are more accurate and dependable metrics when assessing a company's performance.
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