Financial Education

The value of any asset must equal the present value of its future cash flows, discounted at a rate that reflects its inherent risk. Since neither the future cash flows nor the appropriate discount rate can be known with certainty, valuation is inherently an estimation.

Using earnings as cash flow ignores the cost of the equity invested in the firm. This is corrected in Residual Income (RI) models, of which the best known is Economic Value Added (EVA^®). These models deduct a cost of equity capital (the discount rate times beginning shareholder equity) from reported earnings. What remains is residual income – the amount the company earns in excess of the required return.

Since RI models are based on accounting earnings, they may not reflect actual cash flows. However, the models can be more useful than cash flow based models when cash flows are temporarily negative (for example for rapidly growing companies investing significantly in new capital.)

For more information, see all articles on: Investing in Stocks, Valuation

See also:

The Residual Income Valuation Model

Best and Worst Situations for Applying Residual Income Models

Strengths and Weaknesses of the Residual Income Model

Free Cash Flow

Residual Income