Valuing a Company Using the Residual Income Method

Valuing a company or its stock can be accomplished in several ways. You can use a relative valuation approach, comparing multiples and metrics of a firm to other companies within its industry or sector. An alternative would be valuing a firm based on an absolute estimate in an attempt to place an intrinsic value on it such as by implementing discounted cash flow (DCF) modeling or the dividend discount method.

The residual income method is one absolute valuation method that's widely used by analysts to place an absolute value on a firm.

An Introduction to Residual Income

Many people think of excess cash or disposable income when they hear the term "residual income." That definition is correct in the scope of personal finance but residual income is the income generated by a firm after accounting for the true cost of its capital in terms of equity valuation.

You might be wondering if companies don't already account for their cost of capital in their interest expense. Interest expense on the income statement only accounts for a firm's cost of its debt, ignoring its cost of equity such as dividend payouts and other equity costs.

Think of it as the shareholders' opportunity cost or the required rate of return. The residual income model attempts to adjust a firm's future earnings estimates to compensate for the equity cost and place a more accurate value on a firm. The return to equity holders is not a legal requirement like a return to bondholders but firms must compensate investors for investment risk exposure.

The key factor in calculating a firm's residual income is to determine its equity charge. The equity charge is simply a firm's total equity capital multiplied by the required rate of return of that equity. It can be estimated using the capital asset pricing model (CAPM).

Computing Residual Income and the Equity Charge

This formula shows the equity charge equation:

Equity Charge = Equity Capital x Cost of Equity

We need only subtract the equity charge from the firm's net income to come up with its residual income after we've calculated it. Its residual income would look like this if Company X reported earnings of $100,000 last year and financed its capital structure with $950,000 worth of equity at a required rate of return of 11%:

Equity Charge  -  $950,000 x 0.11 = $104,500

Company X is reporting a profit on its income statement but it's economically unprofitable based on the given level of risk when its cost of equity is included in relation to its return to shareholders. This finding is the primary driver behind the use of the residual income method. A company that's profitable on an accounting basis may still not be a profitable venture from a shareholder's perspective if it can't generate residual income.

Intrinsic Value With Residual Income

We must now use this information to formulate a true value estimate for a firm. Like other absolute valuation approaches, the concept of discounting future earnings is put to use in residual income modeling as well. The intrinsic or fair value of a company's stock using the residual income approach can be broken down into its book value and the present values of its expected future residual incomes as illustrated here.

$\begin{aligned} &\text{V}_0 = BV_0 + \left \{ \frac {RI_1}{(1+r)^n} + \frac {RI_2}{(1+r)^{n+1}} + \cdots \right \}\\ &\textbf{where:}\\ &\textit{BV} = \text{Present book value}\\ &\textit{RI} = \text{Future residual income}\\ &\textit{r} = \text{Rate of return}\\ &\textit{n} = \text{Number of periods}\\ \end{aligned}$​V0​=BV0​+{(1+r)nRI1​​+(1+r)n+1RI2​​+⋯}where:BV=Present book valueRI=Future residual incomer=Rate of returnn=Number of periods​

The residual income valuation formula is very similar to a multistage dividend discount model, substituting future dividend payments for future residual earnings. We can derive an intrinsic value for a firm's stock using the same basic principles as a dividend discount model to calculate future residual earnings. The appropriate rate for the residual income strategy is the cost of equity in contrast to the DCF approach which uses the weighted average cost of capital for the discount rate.

The Bottom Line

The residual income valuation approach is a viable and increasingly popular method of valuation. It can be implemented rather easily, even by novice investors. Residual income valuation can give you a clearer estimate of the true intrinsic value of a firm when it's used along with the other popular valuation approaches.