Residual Income

Valuation
What is residual income?
■ Residual income is net income less a charge
(deduction) for common shareholders’
opportunity cost in generating net income.
■ Recent years have seen a resurgence in its use
as a valuation approach, also under such names
as economic profit, abnormal earnings and
Economic Value Added®.

Primary uses of residual income

■ Measurement of internal corporate
performance
■ Estimation of the intrinsic value of common
stock

■ We focus on the residual income model for

valuation of common stock.

Residual income vs traditional

accounting income
■ Traditional financial statements are prepared to reflect
earnings available to owners. Net income includes an
expense to represent the cost of debt capital (interest
expense). Dividends or other charges for equity capital
are not deducted. Traditional accounting leaves to the
owners the determination as to whether the resulting
earnings are sufficient to meet the cost of equity capital.
■ The economic concept of residual income, on the other
hand, explicitly considers the cost of equity capital.

 An example of residual income

Exemple 1 :
Axis Manufacturing Company (AMC) has total assets of
€2,000,000 financed 50% with debt and 50% with equity
capital. The cost of debt capital is 7% pre-tax (4.9%
after tax) and the cost of equity capital is 12%. Net
income for AMC can be determined as follows:
EBIT €200,000
Less: Interest Expense 70,000
Pre-Tax Income €130,000
Income Tax Expense 39,000
Net Income € 91,000
What is it’s residual income?

Continuation of example
■ Another approach that yields the same results is to compare the
firm’s operating profit after taxes to the weighted average cost of
capital (WACC).
■ In the case of AMC, the operating profit after taxes is €140,000
(€200,000 less 30% taxes) or 7% of assets. The firm’s after–tax,
weighted average cost of capital is 8.45%, computed as 50% equity
times the cost of equity of 12% plus 50% debt times the after-tax cost
of debt, 4.9%. The firm is therefore not earning its cost of capital, with
its after-tax weighted average cost of capital exceeding its after-tax
operating return on assets by 1.45%.
■ The equity charge is €169,000 = (8.45% × €2,000,000), which is
higher than it after-tax operating profit of €140,000 by €29,000, the
same figure derived above.

 Other names for residual income

■ Residual income has also been called economic profit since it represents
the economic profit of the firm after deducting the cost of all capital, debt and
equity.
■ The term abnormal earnings is also used. Assuming that over the long term
the firm is expected to earn its cost of capital (from all sources), any earnings
in excess of the cost of capital can be termed abnormal earnings.
■ One example of several competing commercial implementations of the
residual income concept is Economic Value Added (EVA®) trademarked
by Stern Stewart & Company. EVA® is computed as
■ EVA® = NOPAT – (C% х TC)
■ NOPAT is the firm’s net operating profit after taxes,
■ C% is the cost of capital and
■ TC is total capital.

EVA® adjustments
■ In this model both NOPAT and TC determined under generally accepted
accounting principles are adjusted for a number of items to arrive at an
economic measure of income. Some of the more common adjustments:
Research and development expenses are capitalized and amortized rather than
expensed (R&D expense is added back to earnings to compute NOPAT).
For strategic investments which are not expected to generate a return
immediately, a charge for capital is suspended until a later date.
Goodwill is capitalized and not amortized (amortization expense is added back in
arriving at NOPAT and accumulated amortization is added back to capital).
Deferred taxes are eliminated such that only cash taxes are treated as an
expense.
Any inventory LIFO reserve is added back to capital and any increase in the LIFO
reserve is added in arriving at NOPAT.
Operating leases are treated as capital leases and non-recurring items are
adjusted.

 MVA
■ Over time a firm must generate EVA® in order to add market value to
the firm. A related concept is Market Value Added (MVA):
■ MVA = Market Value of the Firm – Capital
■ Similar to the residual income model above, a firm that generates
EVA® should have a market value in excess of the accounting book
value of its capital.

■ Commercial models similar to EVA® and MVA are in use by other

major accounting and consulting firms. These implementations of
the residual income concept are primarily marketed for use in
measuring internal corporate performance and in determining
compensation. Our focus is on the broader concept of residual
income as used in a valuation context.

EVA et MVA (exemple)

▪ La société VBM, Inc. déclare un bénéfice net
d'exploitation de 2 100 $, un CMPC de 14,2 % et
un capital investi de 18 000 $ au début de l'année
et de 21 000 $ à la fin de l'année. débu. Le prix du
marché (en fin d'année) de l'action de l'entreprise
est de 25 $ par action et VBM a 800 actions en
circulation. La valeur marchande (en fin d'exercice)
de la dette à long terme de l'entreprise est de 4
000 $. Calculez l'EVA et la MVA de la VBM.
Capital charges = 14,2%x18000 = 2556
EVA = 2100 - 2556 = -456
MV de la firme = (25x800)+4000 = 24000
MVA =24000 - 21000 =3000

 Residual income model of valuation

■ In the Residual Income Model (RIM) of valuation, the intrinsic value of the firm has two
components:
■ The current book value of equity, plus
■ The present value of future residual income
■ This can be expressed algebraically as
∞
RI t ∞
Et − rBt −1
P0 = B0 + ∑ t
= B0 + ∑ t
■
t =1 (1 + r ) t =1 (1 + r )
■ In the model,
■ B0 is the current book value of equity,
■ Bt is the book value of equity at time t,
■ RIt is the residual income in future periods,
■ r is the required rate of return on equity,
■ Et = net income during period t,
■ RIt = Et – rBt-1.

 Valuing a perpetuity with the

RIM
■ A company will earn $1.00 per share forever, and the company also
pays out all of this as dividends, $1.00 per share. The equity capital
invested (book value) is $6.00 per share. Because the earnings and
dividends will offset each other, the future book value of the stock will
always stay at $6.00. The required rate of return on equity (or the
percent cost of equity) is 10%.
■ 1. Calculate the value of this stock using the dividend discount
model.
■ 2. What will be the residual income each year? Calculate the value
of the stock using a residual income valuation model.
■ 3. Create a table summarizing the recognition of value in the
dividend discount model and the residual income model.

 Perpetuity example
■ Solution to 1. Since the dividend is a perpetuity,
■ P0 = D / r = 1.00 / 0.10 = $10.00 per share.

Perpetuity example
■ Solution to 2. The net income is $1.00 each year, the
book value is always $6.00, and the required return is
10%, so the residual income in every year will be:
■ RIt = Et – rBt-1 = 1.00 – 0.10 (6.00)
= 1.00 – 0.60 = $0.40.
■ The value, using a residual income approach, is the
current book value plus the present value of future
residual income. The residual income is a perpetuity:
■ P0 = Book value + PV of Residual income
= 6.00 + 0.40 / 0.10 = 6.00 + 4.00 = $10.00.

Perpetuity example
■ Solution to 3.

Dividend Discount Model Residual Income Model

Year Dt PV of Dt B0 or RIt PV of B0 or RIt
0 6.00 6.000
1 1.00 0.909 0.40 0.364
2 1.00 0.826 0.40 0.331
3 1.00 0.751 0.40 0.301
4 1.00 0.683 0.40 0.273
5 1.00 0.621 0.40 0.248
6 1.00 0.564 0.40 0.226
7 1.00 0.513 0.40 0.205
8 1.00 0.467 0.40 0.187

Total $10.00 $10.00

RIM valuation vs other DCF models
■ The stylized example presented above demonstrates that
conceptually valuation is not all that different whether a discounted
cash flow approach or residual income model are used. Why then
does the analyst need a residual income model? In a simple cases
such as the perpetuity, both DDM and RIM are easily applied. For
other examples, there are two important differences
■ Timing of recognition of value. Forecasting of future dividends and
cash flows is often difficult. One key advantage to a residual income
model over other models is the timing of the recognition of value. In
DCF approaches most of the value is found in future dividends and in
the terminal value computation. The longer the forecast period the
higher the uncertainty that will exist regarding these future cash flows.
■ Terminal value. Further, as we will see shortly, in many residual
income valuation contexts the terminal value is deemed to be zero.
The determination of book value today is much easier than the
determination of a terminal value ten or twenty years hence.

When to use RIM valuation

A residual income model is most appropriate when:

■ A firm is not paying dividends of if it exhibits an

unpredictable dividend pattern.
■ A firm has negative free cash flow many years out, but is
expected to generate positive cash flow at some point in
the future (for example, a young or rapidly growing firm
where capital expenditures are being made to fuel future
growth.
■ There is a great deal of uncertainty in forecasting terminal
values.

Derivation of the RIM of

valuation
Start with the DDM:
D1 D2 D3
P0 = 1
+ 2
+ 3
+
(1 + r ) (1 + r ) (1 + r )

The relationship between earnings,

dividends and book value is given by the
clean surplus equation as
Bt = Bt −1 + Et − Dt

Derivation of RIM of valuation

■ This means that
■ Dt = Et – (Bt – Bt-1) = Et + Bt-1 – Bt
■ Substituting this into the DDM:
E1 + B0 − B1 E2 + B1 − B2 E3 + B2 − B3
P0 = 1
+ 2
+ 3
+
(1 + r ) (1 + r ) (1 + r )
■ This equation can be simplified:
∞
RI t ∞
Et − rBt −1
P0 = B0 + ∑ t
= B0 + ∑ t
t =1 (1 + r ) t =1 (1 + r )

 Derivation of RIM of valuation

■ This can also be expressed as:
∞
( ROEt − r ) × Bt −1
V0 = B0 + ∑ t
t =1 (1 + r )
■ This equation is logically equivalent to the one above
since
RIt = (ROEt – r)×Bt-1.
Other than the required rate of return, the inputs to the
residual income model are based upon accounting
data.

 RIM of valuation example

Simon Investment Trust (SIT) is expected to earn $4.00, $5.00, and
$8.00 for the next three years. SIT will pay annual dividends of $2.00,
$2.50, and $20.50 in each of these years. The last dividend includes
the liquidating payment to shareholders at the end of year 3 when the
trust will terminate. SIT’s book value is $8 per share and its required
return on equity is 10%.

■ A. What is the current value per share of SIT according to the

dividend discount model?
■ B. Calculate the book value and residual income for SIT for each
of the next 3 years and use those results to find the stock’s value
using the residual income model.
■ C. Calculate return on equity and use it as an input to the residual
income model to calculate SIT’s value.

RIM of valuation example

A. P0 = Present Value of the future dividends
■ P0 = 2/1.10 + 2.50/(1.1)2 + 20.50/(1.1)3
■ P0 = $1.818 + $2.066 + $15.402 = 19.286

B. The book values and residual incomes for the next 3 years are:
■ Year 1 2 3
■ Beginning Book Value 8.00 10.00 12.50
■ Retained earnings (NI–DIV) 2.00 2.50 (12.50)
■ Ending Book Value 10.00 12.50 0.0
■ Net income 4.00 5.00 8.00
■ Less equity charge
(r × Begin Book Val) 0.80 1.00 1.25
■ Residual income 3.20 4.00 6.75

■ P0 = 8.00 + 3.20/1.1 + 4.00/(1.1)2 + 6.75/(1.1)3

■ P0 = 8.00 + 2.909 + 3.306 + 5.071 = 19.286

 RIM of valuation example

C. Year 1 2 3
■ Net income 4.00 5.00 8.00
■ Begin. Bk Value 8.00 10.00 12.50
■ ROE (return on equity) 50% 50% 64%
■ ROE – r 40% 40% 54%
■ Residual income
(ROE–r) × Begin Bk Val 3.20 4.00 6.75

■ P0 = 8.00 + 3.20/1.1 + 4.00/(1.1)2 + 6.75/(1.1)3

■ P0 = 8.00 + 2.909 + 3.306 + 5.071 = 19.286

■ Note: since the residual incomes for each year are necessarily the same in
questions B & C, the results for stock valuation are identical.

 Constant growth residual income

model
■ A firm’s intrinsic value under a residual income can be expressed
as:
ROE − r
V0 = B0 + B0
r−g

■ The first term, B0, reflects the value of assets owned by the firm
less its liabilities.
■ The second term, B0(ROE-r)/(r-g), represents additional value that
is expected due to the firm’s ability to generate returns in excess
of its cost of equity. The second term represents the value of the
firm’s economic profits.
■ If a firm earns exactly the cost of equity the price should equal the
book value per share.

Residual income, dividend, and free

cash flow valuation models
■ Residual income models, dividend discount models, and free cash
flow models are all theoretically sound.
■ The difference is that DDM and FCFE models forecast future cash
flows and find the value of stock by discounting them back to the
present using the required return on equity.
■ The RI model approaches this process differently. It starts with a
beginning value, the book value or investment in equity, and then
makes adjustments to this value by adding the present values of
future residual income (which can be positive or negative).
■ The recognition of value is different, but the total present value of
these values (whether future dividends, future free cash flow, or book
value plus future residual income) should be logically consistent.

Single-stage residual income model

■ A single-stage residual income model

assumes that a firm has a return on equity
and growth rate that are expected to be
constant over time.

ROE − r
V0 = B0 + B0
r−g
Multi-stage residual income
model
■ A multi-stage approach can be used where
residual income is forecast for a certain time
horizon and a terminal value is determined at the
end of the time horizon. The terminal value is
based on continuing residual income.
T
( Et − rBt −1 ) PT − BT
V0 = B0 + ∑ t
+ T
t =1 (1 + r ) (1 + r )
■ Alternately, the equation is:
T
( ROEt − r ) × Bt −1 PT − BT
V0 = B0 + ∑ t
+ T
t =1 (1 + r ) (1 + r )

 Multistage example
Shunichi Kobayashi is valuing United Parcel Service Inc. (NYSE: UPS). Kobayashi has
decided to use the following assumptions:
■ Book value per share is estimated to be $9.62 on December 31, 2001.
■ Earnings per share will be 22% of the beginning book value per share for the next
eight years.
■ Cash dividends paid will be 30% of earnings per share
■ At the end of the eight year period, the market price per share will be three times the
book value per share.
■ The beta for UPS is 0.60. The risk-free rate is 5.00% and the market risk premium is
5.50%.
■ The current market price of UPS is $59.38, which indicates a current a market-to-book
ratio of 6.2. Kobayashi has decided to do the following.
■ A. Prepare a table showing the beginning and ending book values, net income,
and cash dividends annually for the eight year period.
■ B. Estimate the residual income and the present value of residual income for the
eight years.
■ C. Estimate the value per share of UPS stock using the residual income method.
■ D. Estimate the value per share of UPS stock using the discounted dividend
method. How does this value compare to the estimate from the residual income
method?

■ The residual income valuation model has two components

(book value and future earnings) that have a balancing effect
on each other, provided that the clean surplus relationship is
followed. Unfortunately, there are several possible problems
in practice:
■ Violations of the Clean Surplus Relationship
■ Balance Sheet Adjustments for Fair Value
■ Intangible Assets
■ Non-Recurring Items
■ Aggressive Accounting Practices
■ International considerations

 Violations of the clean surplus

relationship
■ Violations of clean surplus accounting occur when accounting standards permit
charges directly to stockholders’ equity, bypassing the income statement.
■ An example is the case of changes in the market value of long-term
investments. International Accounting Standards provide that the change in
market value can be reported either in current profits or in stockholders’ equity.
■ Under U.S. GAAP investments that are considered to be “available for sale” are
included on the balance sheet at market value; however, any change in their
market value is reflected in stockholders’ equity as other comprehensive
income rather than as income on the income statement. (Comprehensive
income is all changes in equity other than contributions by and distributions to
owners.) Comprehensive income includes net income reported on the income
statement. Other comprehensive income is the result of other events and
transactions which result in a change to equity but are not reported on the
income statement. Other items that commonly bypass the income statement
are
foreign currency translation adjustments
certain pension adjustments
fair value changes of some financial instruments

Balance sheet adjustments for fair

value
■ In order to have a reliable measure of book value of
equity, the balance sheet should be scrutinized for
significant off-balance sheet assets and liabilities.
Additionally, reported assets and liabilities should be
adjusted to fair value where possible. Some common
items to review for balance include:
Inventory
Deferred tax assets and liabilities
Pension plan assets and liabilities
Operating leases
Special purpose entities
Reserves and allowances (for example, bad debts)
Intangible assets

Intangible assets
■ For specifically identifiable intangibles that can be separated from the entity (e.g.,
sold), it is appropriate to include these in the determination of book value of
equity. If these assets are wasting (declining in value over time), they will be
amortized over time as an expense.
■ Goodwill, on the other hand, requires special consideration, particularly due to
recent changes in accounting for goodwill. Goodwill is generally not recognized
as an asset unless it results from an acquisition (under most international
accounting standards, internally generated goodwill is not recognized on the
balance sheet). Goodwill represents the excess of the purchase price of an
acquisition over the value of the net assets acquired.
■ Research and development costs provide also must be given careful
consideration. Under U.S. GAAP, R&D is expensed to the income statement
directly. Under IAS, some R&D costs can be capitalized and amortized over time.
While R&D may lead to the existence of an “asset in theory,” this is reflected in
the firm’s ROE and hence residual income over time. If a firm engages in
unproductive R&D expenditures, these will lower residual income through the
expenditures made. If a firm engages in productive R&D expenditures they
should result in higher revenues to offset the expenditures over time. On an
ongoing basis this should be reflected in ROE forecasts for a mature firm.

Nonrecurring items
■ In applying a residual income model, it is important to develop a forecast of future
residual income based upon recurring items.
Often companies report non-recurring charges as part of earnings or classify non-
operating income (e.g., sale of assets) as part of operating income. These
misclassifications can lead over-estimates and under-estimates of future residual
earnings if no adjustments are made. Note that adjustments to book value are not
necessary for these items since non-recurring gains and losses do impact the
value of assets in place. Non-recurring items sometimes result from accounting
rules and at other times result from “strategic” management decisions.
■ An analysts should examine the financial statement notes and other sources for
potential items that may warrant adjustment in determining recurring earnings such as:
Unusual items
Extraordinary items
Restructuring charges
Discontinued operations
Accounting changes
■ In some cases, management may be recording restructuring or unusual charges in
every period. In these cases, the item may be considered an ordinary operating
expense and may not require adjustment.

Other aggressive accounting

practices
■ Firms may engage in accounting practices that result in the overstatement of
assets (book value) and/or overstatement of earnings.
■ Other activities that a firm may engage in include accelerating revenues to the
current period or deferring expenses to a later period. Both activities
simultaneously increase earnings and book value.
For example, a firm might ship unordered goods to customers at yearend, recording
revenues and a receivable.
Conversely, a firm could capitalize rather than expense a cash payment resulting in
lower expenses and an asset.
The analyst must carefully evaluate a firm’s accounting policies and consider the
integrity of management in assessing the inputs in a residual income model.
■ Firms have also been criticized recently for the use of “cookie jar” reserves
where excess losses or expenses are recorded in an earlier period (for example
in conjunction with an acquisition or restructuring) and then used to reduce
expense and increase income in future periods. The analysts should carefully
examine the use of reserves in an assessment of residual earnings.

International considerations
■ Some of the primary considerations internationally are:
The availability of reliable earnings forecasts
Systematic violations of the clean surplus assumption
“Poor Quality” accounting rules that result in delayed recognition
of value changes.
■ We noted earlier that there are differences in standards
worldwide particularly for goodwill and R&D. If the
adjustments recommended in the preceding sections are
made, international comparisons should result in
comparable valuations.

Application 1 (Western Atlantic

Railroad)
▪ Western Atlantic Railroad a une valeur comptable de
23,00 $ par action. Le rendement des nouveaux
investissements de l'entreprise investissements
(ROE) de l'entreprise est de 14%, et le rendement
requis des capitaux propres est de 12%. Le ratio de
distribution des dividendes est de 60 %.
▪ Calculez la valeur des actions à l'aide d'un modèle de
revenu résiduel à une étape et de la valeur actuelle
des bénéfices économiques attendus. bénéfices
économiques attendus.

Application 2 (calcul du taux de

croissance)
▪ Vo u s e n v i s a g e z l ' a c h a t d e Te l l i s
Telecommunications, Inc. qui a un ratio P/B
de 2,50. Le ROE est attendu est de 13%,
la valeur comptable actuelle par action est
de 8,00 € et le coût des capitaux propres
est de 11%. Calculez le taux de croissance
taux de croissance impliqué par le ratio P/
B actuel.
Application 3 (Java Metals)
▪ Java Metals prévoit un rendement des capitaux propres de
15% pour chacune des cinq prochaines années. Sa valeur
comptable actuelle est de 5,00 $ par action, elle ne verse
aucun dividende et tous les bénéfices sont réinvestis. Le
rendement des capitaux propres requis est de 10 %.
▪ Les bénéfices prévus pour les années 1 à 5 sont égaux au
ROE multiplié par la valeur comptable initiale. Calculez la
valeur intrinsèque de l'entreprise en utilisant un modèle de
revenu résiduel, en supposant qu'après cinq ans, le revenu
résiduel continu tombe à zéro. revenu résiduel continu tombe
à zéro.