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Residual Income Model (RIM): Definition, Formula, and Calculation
The Residual Income Model (RIM) is a stock valuation technique that takes the cost of equity into account, unlike most other approaches.
FORMULA
Residual Income = Net Income - Equity Capital x Cost Of Equity
Big ideas
- The RIM evaluates the economic profit of a firm as opposed to the accounting profit of a firm.
- Residual income is the income created by a company after the cost of capital has been taken into account, particularly the cost of equity.
What is the Residual Income Model (RIM)?
The Residual Income Model (RIM) is an evaluation technique that is an alternative to the Dividend Discount Model (DDM) and the Discounted Cash Flow model (DCF).
The main premise is that the company value is a function of the Present Value (PV) of future residual incomes, discounted by the cost of equity. It focuses on the Book Value of Equity (BVE), setting it apart from both the DDM and DCF.
It further places an emphasis on the true cost of capital, which is the cost of both debt and equity. Usually, when doing the accounts to arrive at a profitability figure, only the cost of debt is accounted for.
Even when a company reports an accounting profit, it could mean an economic loss, if the cost of equity has not been factored in.
The equity charge is the cost associated with the capital provided by shareholders, essentially representing the required return on equity. The required return on equity (ROE) is the minimum rate of return that investors expect to earn from a company’s shares in exchange for taking on the risk of investing their capital.
The main premise is that the company value is a function of the Present Value (PV) of future residual incomes, discounted by the cost of equity. It focuses on the Book Value of Equity (BVE), setting it apart from both the DDM and DCF.
It further places an emphasis on the true cost of capital, which is the cost of both debt and equity. Usually, when doing the accounts to arrive at a profitability figure, only the cost of debt is accounted for.
Even when a company reports an accounting profit, it could mean an economic loss, if the cost of equity has not been factored in.
The equity charge is the cost associated with the capital provided by shareholders, essentially representing the required return on equity. The required return on equity (ROE) is the minimum rate of return that investors expect to earn from a company’s shares in exchange for taking on the risk of investing their capital.
FORMULA
Equity Charge = Equity Capital x Cost Of Equity
Residual Income (RI) is neatly defined as the net income minus the equity charge.
The equity charge accounts for the cost of equity, being equal to the equity capital times the cost of equity. However, after this calculation has taken place, it can get more complicated to derive the present value of future discounted residual incomes.
The equity charge accounts for the cost of equity, being equal to the equity capital times the cost of equity. However, after this calculation has taken place, it can get more complicated to derive the present value of future discounted residual incomes.
The Residual Income Formula explored
The basic residual income formula is merely the net income minus the equity charge. Provided the company offers a residual income above the required rate of return, economic value is being generated for shareholders.
EXAMPLE
We can take a simple example to calculate the residual income, with the following criteria:
• Net income = £200,000
• Equity = £2 million
• Required return on equity = 8%
Calculation
1. Residual income = Net Income - Equity Charge
2. Equity charge = £2,000,000 × 0.08 = £160,000
3. Residual income = £200,000 − £160,000 = £40,000
Interpretation
This company’s residual income is £40,000. This means that it earned £40,000 above the required shareholder rate. It is therefore adding value beyond the cost of capital tied to the equity.
• Net income = £200,000
• Equity = £2 million
• Required return on equity = 8%
Calculation
1. Residual income = Net Income - Equity Charge
2. Equity charge = £2,000,000 × 0.08 = £160,000
3. Residual income = £200,000 − £160,000 = £40,000
Interpretation
This company’s residual income is £40,000. This means that it earned £40,000 above the required shareholder rate. It is therefore adding value beyond the cost of capital tied to the equity.
However, the calculation of the intrinsic value of a stock using RIM can be a lot more complicated than merely obtaining the residual income itself.
Calculating a stock’s intrinsic value through residual income
To calculate the intrinsic value of a stock using RI, future cash flows need to be discounted. This can be achieved using the cost of equity as the discount rate (in contrast to the Weighted Average Cost of Capital observed in the DCF approach).
FORMULA
Intrinsic Value = Book Value of Equity + Present Value of Future Residual Income
Where:
• Book value of equity = assets minus liabilities
• Residual income = net income minus the equity charge
• Present value of future residual income = each year’s residual income is discounted back to the present using the required rate
Where:
• Book value of equity = assets minus liabilities
• Residual income = net income minus the equity charge
• Present value of future residual income = each year’s residual income is discounted back to the present using the required rate
EXAMPLE
Residual income calculation
We can calculate the intrinsic value of Unilever PLC using the residual income model and the below hypothetical figures:
• Book value of equity = £15 billion
• Net income = £5 billion
• Required rate of return (r) = 9%
• Equity charge = £15 billion × 9% = £1.35 billion
• Residual income for the current year = £5 billion – £1.35 billion = £3.65 billion
For this example, we assume that Unilever's residual income will remain stable over the next three years.
Intrinsic value calculation
PV of residual income over 3 years:
PV = £3.65b/1.09 + £3.65b/1.09² + £3.65b/1.09³
This equals approximately £9.42 billion.
Intrinsic Value = BVOE + PV = £15 billion + £9.42 billion = £24.42 billion
Interpretation
The intrinsic value of Unilever’s equity is estimated to be £24.42 billion. If the company’s current market cap is below this value, it may indicate that the stock is undervalued.
Past performance is no guarantee of future results. This information is not investment advice. Do your own research. The calculations are hypothetical and intended solely for educational use.
We can calculate the intrinsic value of Unilever PLC using the residual income model and the below hypothetical figures:
• Book value of equity = £15 billion
• Net income = £5 billion
• Required rate of return (r) = 9%
• Equity charge = £15 billion × 9% = £1.35 billion
• Residual income for the current year = £5 billion – £1.35 billion = £3.65 billion
For this example, we assume that Unilever's residual income will remain stable over the next three years.
Intrinsic value calculation
PV of residual income over 3 years:
PV = £3.65b/1.09 + £3.65b/1.09² + £3.65b/1.09³
This equals approximately £9.42 billion.
Intrinsic Value = BVOE + PV = £15 billion + £9.42 billion = £24.42 billion
Interpretation
The intrinsic value of Unilever’s equity is estimated to be £24.42 billion. If the company’s current market cap is below this value, it may indicate that the stock is undervalued.
Past performance is no guarantee of future results. This information is not investment advice. Do your own research. The calculations are hypothetical and intended solely for educational use.
The practical applications of Residual Income Valuation
Residual Income Valuation is a useful tool for assessing a company’s financial performance and investment potential. It focuses on the net income generated by a company after deducting the cost of equity capital.
It helps investors identify undervalued stocks and assess management effectiveness, by examining whether the company is creating or destroying shareholder value.
It is also valuable in corporate finance for capital budgeting decisions and performance measurement.
In investment analysis, residual income valuation provides a more refined approach than traditional metrics, such as earnings per share (EPS). It enables investors to:
It is also valuable in corporate finance for capital budgeting decisions and performance measurement.
In investment analysis, residual income valuation provides a more refined approach than traditional metrics, such as earnings per share (EPS). It enables investors to:
- Evaluate a company's profitability after considering the cost of capital
- Helping to identify firms that generate true economic profit
- Screen potential investment opportunities
- Compare companies across industries by normalising returns
- Forecast future performance, allowing investors to make data-driven decisions
Advantages of using the Residual Income Model
The main advantage of using the Residual Income Model is that it accounts for the cost of equity as well as debt. On a company’s income statement, the interest expense only accounts for the cost of debt. Equity costs, such as dividend payouts, are not taken into consideration.
Beyond that RIM does offer several benefits:
✅ Focus on economic profit - RIM emphasises economic value creation by accounting for the cost of equity, unlike other models that only consider accounting profits. This makes it more aligned with shareholder value.
✅ Useful for firms with negative cash flows - since it is based on accounting data rather than cash flows, the RIV model can be applied to firms that may not currently generate positive free cash flow but are expected to create value over time.
✅ Less sensitive to terminal value estimates - unlike DCF models, where a large portion of value depends on terminal value assumptions, the RIV model reduces this dependency by incorporating book values and residual income projections over multiple periods.
✅ Handles accounting distortions - by focusing on residual income, the model adjusts for biases in reported earnings, providing a clearer picture of true economic performance.
✅ Applicable across different stages of growth - the model works well for firms at various stages, even when future earnings are uncertain or inconsistent, as long as book values and expected income streams are available.
Commercially, the Residual Income Model (RIM) is implemented through the Economic Value Added (EVA) approach, which uses the Weighted Average Cost of Capital (WACC).
Beyond that RIM does offer several benefits:
✅ Focus on economic profit - RIM emphasises economic value creation by accounting for the cost of equity, unlike other models that only consider accounting profits. This makes it more aligned with shareholder value.
✅ Useful for firms with negative cash flows - since it is based on accounting data rather than cash flows, the RIV model can be applied to firms that may not currently generate positive free cash flow but are expected to create value over time.
✅ Less sensitive to terminal value estimates - unlike DCF models, where a large portion of value depends on terminal value assumptions, the RIV model reduces this dependency by incorporating book values and residual income projections over multiple periods.
✅ Handles accounting distortions - by focusing on residual income, the model adjusts for biases in reported earnings, providing a clearer picture of true economic performance.
✅ Applicable across different stages of growth - the model works well for firms at various stages, even when future earnings are uncertain or inconsistent, as long as book values and expected income streams are available.
Commercially, the Residual Income Model (RIM) is implemented through the Economic Value Added (EVA) approach, which uses the Weighted Average Cost of Capital (WACC).
Limitations of the residual income model
It is not as popular as the DCF formula, and there are distinct reasons for this. The Residual Income Valuation model has several limitations:
❌ Dependence on accounting data - it relies heavily on reported earnings and book values, which can be affected by accounting choices, estimates, or inconsistencies across firms and industries.
❌ Assumptions on cost of equity - the accuracy of the model depends on correctly estimating the cost of equity, which can be challenging and subjective, especially for firms with volatile risk profiles.
❌ Limited use for financial firms - banks and other financial institutions have complex accounting structures, making it harder to apply the RIV model consistently.
❌ Sensitivity to forecast accuracy - the model requires reliable forecasts of residual income over several years. Small errors in projections can have significant impacts on valuation.
RIM can also be difficult to compute and may not be suitable for all firms; particularly those with cyclical or unpredictable earnings.
❌ Dependence on accounting data - it relies heavily on reported earnings and book values, which can be affected by accounting choices, estimates, or inconsistencies across firms and industries.
❌ Assumptions on cost of equity - the accuracy of the model depends on correctly estimating the cost of equity, which can be challenging and subjective, especially for firms with volatile risk profiles.
❌ Limited use for financial firms - banks and other financial institutions have complex accounting structures, making it harder to apply the RIV model consistently.
❌ Sensitivity to forecast accuracy - the model requires reliable forecasts of residual income over several years. Small errors in projections can have significant impacts on valuation.
RIM can also be difficult to compute and may not be suitable for all firms; particularly those with cyclical or unpredictable earnings.
Comparing Residual Income Valuation with other models
Sometimes, the best way to understand a given model is to compare it with others. RIM, EPS, DDM, and DCF are all methods used to assess the profitability of a company; they are known as valuation models, placing them in the same loose category. However, each valuation model tells a different story, using different criteria.
Valuation Model | Description | Strengths | Weaknesses |
Residual Income Valuation (RIM) | Calculates intrinsic value based on net income after deducting a charge for the cost of equity capital. | Focuses on true economic profit; aligns with shareholder value creation; useful for companies with no dividends. | May be difficult to implement for firms with inconsistent earnings; requires a reliable estimate of equity cost. |
Earnings per Share (EPS) | Measures a company's profitability on a per-share basis. Calculated as net income divided by the number of outstanding shares. | Simple to calculate; widely recognised and used; easily comparable across firms. | Does not account for capital structure; can be manipulated through accounting practices; does not reflect future growth. |
Discounted Cash Flow (DCF) | Values a company based on its expected future cash flows, discounted back to present value. | Comprehensive approach; considers the time value of money; adaptable to various scenarios. | Highly sensitive to assumptions (growth rates, discount rates); can be complex; requires detailed forecasts. |
Dividend Discount Model (DDM) | DDM values a company as per the present value of its projected future dividends. | Simple and intuitive; effective for stable, dividend-paying companies; directly links cash flows to shareholders. | Not applicable to non-dividend-paying companies; assumes constant growth in dividends; sensitive to growth rate assumptions. |
Summary of each valuation model
Each model has its strengths and weaknesses, making them suitable for different scenarios depending on the company's characteristics and investor objectives.
- RIM highlights value creation beyond mere earnings, focusing on economic profit, though it can be challenging to calculate accurately.
- EPS is straightforward but can mislead if earnings are not a reliable measure of value.
- DCF offers a deeper analysis of future potential but is complex and relies on estimates.
- DDM is effective for dividend-focused investors but may not be suitable for growth-oriented firms.
Recap
Residual income is useful as far as equity value is concerned. A company with a net income of £100,000 but with an equity charge of £110,000 is not economically profitable, even if it is profitable from an accounting perspective.
However, any model is only as strong as its underlying assumptions. RIM assumes that the company will reinvest its earnings at the cost of equity and neglects other forms of capital.
Moreover, correctly estimating the cost of equity can be challenging, and the RIM formula depends on an accurate figure, with small errors resulting in severe valuation distortions.
However, any model is only as strong as its underlying assumptions. RIM assumes that the company will reinvest its earnings at the cost of equity and neglects other forms of capital.
Moreover, correctly estimating the cost of equity can be challenging, and the RIM formula depends on an accurate figure, with small errors resulting in severe valuation distortions.
FAQ
Q: What does Residual Income Valuation tell us?
Residual Income Valuation (RIV) measures the amount of income a company generates above its required return on equity. It helps assess whether a company creates value for its shareholders. If a firm has positive residual income, it is typically considered to be performing well, indicating effective use of capital.
Q: Why use Residual Income instead of ROI?
Residual income provides a more complete view of profitability than Return on Investment (ROI). While ROI measures efficiency relative to invested capital, residual income considers the cost of equity, revealing whether a company earns more than its cost of capital. This approach helps identify truly profitable investments.
Q: Is it better to have a higher or lower Residual Value?
A higher Residual Value is better. It indicates that a company is generating more profit than the minimum required return on its equity. This situation suggests that management is creating value for shareholders, reflecting strong operational performance and effective capital allocation.
Q: How do you interpret Residual Value?
Residual Value represents the estimated value of an asset at the end of its useful life. In the context of residual income, it indicates the expected future profitability of a company beyond the cost of capital. A positive residual value signals that the company can continue generating profits after accounting for the cost of equity.
Q: What are the disadvantages of Residual Income Valuation?
Residual Income Valuation has some limitations. It relies heavily on accurate estimates of future earnings and required returns, which can be uncertain. Additionally, it may not be suitable for companies with fluctuating earnings or those that are not profitable, making it harder to apply consistently across different firms or industries.
- Weighted Average Cost of Capital (WACC): A company’s average cost of raising money from both debt and equity, weighted by how much of each source it uses in its financial structure.
- Dividend Discount Model (DDM): A share-valuation approach that calculates the present value of all future dividends, considering how much those dividend payments are likely to grow over time.
- Discounted Cash Flow (DCF): A method of valuing a business or investment by projecting future cash flows and then adjusting them to today’s money using a chosen discount rate.
- Economic Value Added (EVA): A performance measure assessing how much profit exceeds (or falls short of) the full cost of capital, including both debt and equity.
- Earnings per Share (EPS): An indicator showing how much net profit is attributed to each individual share, often used to gauge company profitability.
