Residual Income Valuation
Prof. Dr. Martin Užík
Residual Income
2
-
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
3
-
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.
4
Residual Income Calculation
-
One approach is to compute the cost of equity capital (in terms of
currency), which we term an equity charge, and subtract this from net
income, as follows:
-
Equity Charge = Equity Capital х Cost of Equity Capital in %
Tax Rate
Total Assets
Equity Ratio
Debt Ratio
rD (Cost of Debt)
rCAPM
EBIT
Interest Expenses
EBT
Tax Expenses
EAT (Net Income)
Equity Charge = Cost of Equity (in EUR)
Residual Income
5
30%
870.000,00 €
40%
60%
5,4%
13,5%
115.000,00 €
28.188,00 €
86.812,00 €
26.043,60 €
60.768,40 €
46.980,00 €
13.788,40 €
Tax Rate
30%
Total Assets
870.000,00 €
Equity Ratio
40%
Debt Ratio
60%
rD (Cost of Debt)
5,4%
rCAPM
13,5%
EBIT
35.000,00 €
Interest Expenses
28.188,00 €
EBT
6.812,00 €
Tax Expenses
2.043,60 €
EAT (Net Income)
4.768,40 €
Equity Charge = Cost of Equity (in EUR)
46.980,00 €
Residual Income
- 42.211,60 €
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
-
6
EVA® = (rROCE – rWACC) x Capital
-
NOPAT is the firm’s net operating profit after taxes,
-
rROCE = return on capital employed
-
C is total capital.
rROCE 
NOPAT
Capital
Residual income vs traditional accounting income
In the Residual Income Model (RIM) of valuation, the intrinsic value of the firm has
two components:
1. The current book value of equity, plus
2. The present value of future residual income
This can be expressed algebraically as

RI t
Et  rBt 1
P0  B0  
 B0  
t
t
(
1

r
)
(
1

r
)
t 1
t 1

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.
7
RIM Valuation
Tax Rate
Total Assets
Equity Ratio
Debt Ratio
rD (Cost of Debt)
rCAPM
EBIT
Interest Expenses
EBT
Tax Expenses
EAT (Net Income)
Equity Charge = Cost of Equity (in EUR)
Residual Income
Nomber of Shares
eps (earnings per share)
book equity Value per share
rCAPM
RI per share
Share Price
30%
870.000,00 €
40%
60%
5,4%
13,5%
115.000,00 €
28.188,00 €
86.812,00 €
26.043,60 €
60.768,40 €
46.980,00 €
13.788,40 €
13000
4,67 €
26,77 €
0,14 €
1,06 €
34,63 €

RI t
Et  rBt 1
4,67  0,135 * 26,77
P0  B0  

B


26
,
77

 34,63

0
t
t
0,135
t 1 (1  r )
t 1 (1  r )

8