Definition
The residual income model values equity as book value plus the present value of future residual income (earnings above the required return on equity). It is useful when free cash flow is negative or volatile, and works well for financial institutions. The model explicitly links value creation to earning returns above the cost of capital.
functions Formula
Value = Book Value + Σ(Residual Income_t / (1+r)^t)
lightbulb Example
Book value is $20/share, ROE is 15%, cost of equity is 10%, equity per share is $20. Residual income = (15%-10%) × $20 = $1.00/share. If residual income persists for 10 years, value ≈ $20 + PV($1.00 × 10 years).
verified_user Key Points
- Useful when FCF is negative or volatile
- Links value to economic profit creation
- Works well for banks and financial institutions
- Based on accounting data readily available