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people will buy stocks? They will be better off by buying a bank deposit or bonds where risk of
loss is negligible. By maintaining a higher cost of equity, companies keep investors interested in
their stocks. Higher cost of capital means ensures more trading of stocks. More trading means
higher volume. Popular stocks has higher trading volume.
A company with higher residual income should be the preferred choice of investors. When two
companies has the same net profit (PAT), choice of investors shall be one with higher residual
income. One of the biggest cost of equity is dividend payment to shareholders. Dividend is paid
on both preference shares and equity shares. Cost of equity component in our formula is related
to total dividend paid + expected return.
Once we have calculated the equity charge, we only have to subtract it from the firm's net
income to come up its residual income. For example, 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%, its residual income would be:
Equity Charge
Net Income
$100,000
Equity Charge
-$104,500
Residual Income
-$4,500
So as you can see from the above example, using the concept of residual income, although
Company X is reporting a profit on its income statement (which it should), once its cost of equity
is included in relation to its return to shareholders, it is actually economically unprofitable based
on the given level of risk. This finding is the primary driver behind the use of the residual income
method. A scenario where a company is profitable on an accounting basis, it may still not be a
profitable venture from a shareholder's perspective if it cannot generate residual income.
FORMULA FOR VALUATION
In residual income approach, a companys stock value can be calculated as sum total of its book
value and its expected future residual incomes present value which is discounted at cost of
equity, the general formula is:
This formula is used when it is assumed that the company will achieve maturity or constant
growth. Here, for calculating the corresponding terminal value, mainly perpetual growth model
is used. The terminal value when it is assumed long run constant growth g from year m is:
Keep in mind that the RI model (like the Gordon Growth Model) can be used to derive a
growth rate, when current and expected share prices are given.
MULTI-STAGE RI MODEL
Just as the dividend discount model and the free cash flow discounting models can have
multiple stages, so can the residual income model.
This requires calculation of a terminal value of the residual income at the end of the
abnormal growth phase.
In contrast to the terminal value in a multi-stage DDM, the terminal value in a multi-stage RI
model will be much smaller, as it will only capture the terminal value of residual income
following the high growth period and not the terminal value of the share price.
In the RI model, much of the value is front-loaded because the model uses the book value of
equity as a starting point.
DISADVANTAGES
o The model is vulnerable to accounting manipulation by company management.
o The model requires that the analyst have sophisticated understanding of public
financial reporting, as large adjustments to report financials may be required.
APPROPRIATENESS
o The RI model can be utilized when: the company does not pay dividends; free
cash flows are expected to be negative; or when there exists a high level of
uncertainty around the terminal value.
THE BOTTOM LINE
The residual income approach offers both positives and negatives when compared to the more
often used dividend discount and DCF methods. On the plus side, residual income models make
use of data readily available from a firm's financial statements and can be used well with firms
who do not pay dividends or do not generate positive free cash flow. Residual income models
look at the economic profitability of a firm rather than just its accounting profitability. The
biggest drawback of the residual income method is the fact that it relies so heavily on forward
looking estimates of a firm's financial statements, leaving forecasts vulnerable to psychological
biases or historic misrepresentation of a firms financial statements. When used alongside the
other popular valuation approaches, residual income valuation can give you a clearer estimate of
what the true intrinsic value of a firm may be.