Lecture 12

Residual Income Valuation

Residual income
Residual income (RI), or economic profit, is the net
income of a firm less a charge that measures
stockholders opportunity cost of capital
The rationale for the residual income approach is that it
recognizes the cost of equity capital in the
measurement of income.
Accounting net income includes a cost of debt (i.e.,
interest expense), but does not reflect dividends or
other equity capital-related funding costs.
Conversely, residual income explicitly deducts all capital

Residual income - Calculation

MFS, Inc. distributes fruit to grocery stores in large U.S.
cities. The book value of its assets is $1.4 billion, which
is financed with $800 million in equity and $600 million
in debt. Its before-tax cost of debt is 3.33%, and its
marginal tax rate is 34%. MFS has a cost of equity of
12.3%. If the companys EBIT is $ 142 million calculate
its RI.
Ans: $17,880,000

Economic value added

EVA measures the value added for shareholders by
management during a given year.
EVA is calculated as:

Market value added (MVA)

Market value added (MV A) is the difference between
the market value of a firms long-term debt and equity
and the book value of invested capital supplied by
investors.
It measures the value created by managements
decisions since the firms inception. MVA
is calculated as:

EVA & MVA - Calculations

Company A reports NOPAT of $2,100, a WACC of 14.2%,
and invested capital of $18,000. The market price of the
firms stock is $25 per share, and VBM has 800 shares
outstanding. The market value of the firms long-term
debt is $4,000. Calculate EV A and MVA.
Ans: $456 and $6,000

Calculate the intrinsic value using the

residual income model
We can forecast residual income given some basic
accounting information and an estimate of future
earnings growth using the following formula:

Calculate the intrinsic value using the

residual income model
Example:
Assume a required rate of return of 11%. Forecast
residual income for 2009 and 2010 by using following
data:

Calculate the intrinsic value using the

residual income model
The residual income valuation model breaks the intrinsic
value of a stock into two elements: (1) current book
value of equity and (2) present value of expected future
residual income:

Calculate the intrinsic value using the

residual income model
Example:
CPP has a required rate of return of 14%. The current book value
is C$6.50. Earnings forecasts for 2009, 2010, and 2011 are
C$1.10, C$1.00, and C$0.95, respectively. Dividends in 2009 and
2010 are forecasted to be C$0.50 and C$0.60, respectively. The
dividend in 2011 is a liquidating dividend, which means that CPP
will pay out its entire book value in dividends and cease doing
business at the end of 2011. Calculate the value of CPPs stock
using the residual income model.
Ans: C$6.61

Calculate the intrinsic value using the

residual income model
Example:
WR Inc. has a book value of $23.00 per share. The
companys return on new investments (ROE) is 14%, and
its required return on equity is 12%. The dividend payout
ratio is 60%. Calculate the value of the shares using a
single-stage residual income model and the present
value of expected economic profits.
Ans: $30.19 and $7.19
Formula: