RESIDUAL INCOME VALUATION-ALL YOU NEED TO KNOW

Residual income valuation (also known as residual income model or residual income method) is an equity valuation method that is based on the idea that the value of a company’s stock equals the present value of future residual incomes discounted at the appropriate cost of equity.

RESIDUAL INCOME= NET INCOME-EQUITY CAPITAL X COST OF EQUITY

Benefits of Residual Income Valuation

Residual income method is a unique and a comparatively easier way to estimate intrinsic value of companies. What makes it unique is the factor called “residual income“. Generally, residual income valuation is suitable for mature companies that do not give out dividends or follow unpredictable patterns of dividend payments. In this regard, the residual income model is a viable alternative to the dividend discount model (DDM).

Additionally, it works well with companies that do not generate positive cash flows yet. However, an analyst must be aware that such an approach is based mostly on forward-looking assumptions that can be manipulated or are prone to various biases.

Along with the discounted cash flow (DCF) model, residual income valuation is one of the most recognized valuation approaches in the industry. Although the approach is less well-known, the residual income model is widely used in investment research. (Note that residual income valuation is an absolute valuation model that aims to determine a company’s intrinsic value).

Basically there are five  steps that an analyst must follow in the study of intrinsic value of companies using residual income model:

1. Expected Returns: Before one can start the process of intrinsic value estimation, it is necessary to start on the right foot. We can do it by tuning our return expectations. We will see how this can be done.
2. Cost of Equity: Estimating right return values will lead us to ‘cost of equity’. It is one of the key ingredients of residual income. Understanding the concept of cost of equity is important.
3. Residual Income: It is essential to understand the concept of residual income. What we should know? What is residual income? How it is meaningful for investors? How it can help analysts to estimate intrinsic value?
4. Intrinsic Value: Once we have followed all of the above three steps, calculation of intrinsic value will be easy. But what is important at this step is to convert all residual incomes calculated in step #3 to their present value.
5. Compare Price: Comparing the estimated intrinsic value with current price will give an idea about stock being overvalued or undervalued. Why undervaluation check is necessary? Because undervalued stocks have a stronger tendency of future price appreciation.