Residual Income Valuation

A valuation method that takes the future earnings less the cost of capital and discounts it to the present to estimate the value of a security.

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.

What Is Residual Income Valuation (RIV)?

In theory, residual income (RI) 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 RIV 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, RI 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 RIs 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.

Scenarios And Illustrations

RI 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.

1. Ex: 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, RI 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.

2. Ex: Scenario 2

If, 

Residual Income (RI) = 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 RI 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, RI 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 RIV 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 RI would be,

RI = OI - Equity Charge.

This can also be put as

RI = 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)

3. Ex: Scenario-3

Scenario 03
Net Income$120,000
Equity Capital $950,000
Cost Of Equity11%

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 RI even though the organization is profitable on paper. 

The RI in this scenario will be a negative $22,500. Since the equity charge will $950,000 times 15% that equals to $142,5000.

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.

Benefits

It's suitable for grown, stable, and mature companies to use RIV. 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.

Limitations

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. 

Key Takeaways
  • Residual Income(RI) is the excess funds after the capital or equity charge.
  • The Capital charge is the assets of the business unit times the required rate of return.
  • The required rate of return can be the minimum rate of return or the WACC.
  • The RI model is used for valuation. It can also be used to determine the cost the company should spend to acquire the targeted company.
  • This valuation in other iterations is used to value equity. Assuming that the value of the company's stock equals the PV of future residual incomes discounted at the appropriate cost of equity capital.
  • It's an absolute model.
  • The model works better on mature companies with stable growth rates.
  • It is as accurate as the financial statements since the primary information is borrowed from the financial statements.
  • Ignores the cash aspect and focuses on accrual-based numbers.
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Researched and authored by Farooq Azam Khan, CMA | LinkedIn

Reviewed and Edited by Aditya Salunke | LinkedIn

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