In the context of corporate finance, Residual Income (RI) is understood as the positive amount that results after subtracting the cost of capital from the business’ net earnings. This residual income is employed as a variable to value a company, same as cash flow is employed in valuation methods such as the Discounted Cash Flow model (DCF).
The residual income takes out the portion of the cost of capital associated to equity, since the cost of debt is already taken out in the form of the interest expense that is deducted from income at a previous stage.
What is Residual Income?
Contents
Residual income is also known as economic value added (EVA) or economic profit. In any case, these terms indicate a calculation that takes out the cost of equity required to achieve the business’ net income.
Financial analysts employ Residual Income (RI) mostly for valuation purposes. The Residual Income Valuation method uses the current book value of the firm and adds up the present value of future residual incomes generated by the firm, to estimate the current market value of the business.
This metric becomes highly valuable when the firm don’t have a steady stream of Free Cash Flow coming in, perhaps due to the fact that is constantly reinvesting profits back into the business. When this is the case, the Residual Income Valuation method becomes useful, as it employs earnings rather than cash flow.
Residual Income Formula
The formula to calculate Residual Income is the following:
RI = Net income – (Equity * Cost of Equity)
Residual Income Equation Components
Net Income: Net earnings after deducing all costs, expenses, depreciation, amortization, interest charges and taxes from the business revenues.
Equity: The total equity as stated in the Balance Sheet.
Cost of Equity: The minimum rate of return the company’s shareholder expect on their investment in the business.
Furthermore, the Residual Income valuation method formula goes as following:
Residual Income Calculations
V0 = Market Value of the Firm
BV0 = Current Book Value of the Firm
RI = Residual Income
r = Cost of equity
t = Time period
The result in both cases would be a certain amount of money.
Residual Income Example
Doggy Industries is a company that produces different types of food for pets, mainly for dogs and cats. The company has been in business for more than 3 years and has been gaining market share in the different segments it serves. Right now, the company needs additional funds to expand its operations and the Board of Directors decided to issue new shares for those interested in investing in the business.
The main issue right now is to determine a fair value for the business, in order to issue the new shares. Since the business only has a few years, the Discounted Cash Flow model is not the right fit for the valuation. Instead, they will employ the Residual Income Valuation method, and the calculations went as following:
Net Income – last year: $3,445,000
Total Equity: $16,000,000
Book Value: $12,500,000
Cost of Equity: 11%
Total Shares Outstanding: 1,000,000
With this information, the Residual Income for the firm will be:
RI = $3,445,000 – ($16,000,000 * 11%) = $1,685,000
Therefore, the current market value of Doggy Industries, according to the Residual Income Valuation method will be:
V0 = $12,500,000 + ($1,685,000 / (1,11)^1) + ($1,685,000 / (1,11)^2) + ($1,685,000 / (1,11)^3) + ($1,685,000 / (1,11)^4) + ($1,685,000 / (1,11)^5)
V0 = $18,727,586.
Estimate price per share = $18.73
According to this valuation, the company should issue shares at $18.73 each.
Residual Income Ratio Analysis
The Residual Income metric has special importance to investors, as it unveils the actual value created from the business. A residual income of 0 is not necessarily a bad thing, as it means that the company is producing enough money to cover for the cost of the equity it employs to produce it. Nevertheless, businesses with a residual income higher than 0 will become more valuable over time, as they exceed the investor’s expected return.
This Residual Income is translated into a higher value per share, as seen in the example above. If we substitute the Residual Income value above for 0 on each of the time periods, the value of the company would be its book value right now, since the business has no capacity to generate anything else aside from the expected rate of return.
Businesses like Apple, Google and Amazon have seen the price of their stocks skyrocket due to the fact that the underlying business is producing returns that surpass the cost of equity, which translates into a higher price per share.
Investment bankers, investors and financial analysts employ these metrics and valuation techniques on a daily basis to estimate the value of companies they are inclined to invest in. They may find that some companies are trading at a price per share lower than the price per share estimated through a model such as the Residual Income Valuation method, in those cases, the investment will be seen as a potential ‘buy’.
Residual Income Uses, Cautions, Pitfalls
One of the most difficult things to determine to calculate residual income is the cost of equity. The cost of equity can be arbitrarily set by the investor, if it is the minimum expected return he would like to receive from the investment, or it can be estimated through certain models such as the Capital Asset Pricing Model (CAPM), which incorporates the return on a risk-free asset available in the market with the risk premium associated to the type of business.
Even though the CAPM is far from being 100% accurate, it helps investors in the task of determining what should be the minimum rate of return they should expect from their investment.
On the other hand, determining the investment horizon for the stock is also not an easy task, as any year that is left out of the calculation is a year where the company will potentially generate valuable returns. As a solution for this situation, some models incorporate a perpetuity after the investment horizon ends. This perpetuity basically states that the company will continue to generate the same Residual Income for the remaining years to come.