A company can report positive net income every year and still destroy shareholder value. Residual income valuation exists because the income statement charges you for debt capital but never for equity capital.
Residual income is net income minus a charge for the opportunity cost of equity capital. Interest expense already sits on the income statement, so lenders are paid. Shareholders are not: nothing on the income statement deducts what equity investors could have earned elsewhere. Residual income fixes that by subtracting an equity charge, equal to the required rate of return on equity multiplied by the book value of equity.
The cost of equity here is a marginal cost, the required return on additional equity whether raised externally or retained internally. If a company also has preferred stock, subtract preferred dividends from net income first.
An equivalent route starts from net operating profit after taxes (NOPAT) and subtracts a total capital charge covering both debt and equity.
Common mistakes
- Using average book value for ROE. The model requires beginning book value in the denominator. Using the average of $6.00 and $7.00 instead of $6.00 in Example 1 understates Year 1 ROE and corrupts every subsequent residual income figure.
- Charging equity on ending book value. The equity charge is . Applying 10% to Year 1's ending $7.00 rather than the beginning $6.00 gives $0.70 instead of $0.60 and shifts the whole schedule.
- Double-counting book value. enters once as the leading term. Adding a discounted terminal book value on top of and the residual income stream inflates value; the terminal term is the premium , not .
Bottom line
- Residual income = net income − equity charge, where the equity charge is r × beginning book value of equity
- EVA = NOPAT − (C% × TC); MVA = market value of the company − accounting book value of total capital
- Model: value = current book value per share + PV of expected future per-share residual income, with RI = (ROE − r) × beginning book value
- Clean surplus required: ending book value = beginning book value + earnings − dividends; other comprehensive income breaks it
Exam shortcut
Build the schedule before you touch a discount factor: beginning book value, EPS, dividend, ending book value, equity charge, residual income. Beginning book value drives both ROE and the equity charge; if a choice differs from yours by a factor near r, you used the wrong end of the year.
The full lesson (about 3,531 words, 24 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- residual income valuation
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