Financial Education

When used to value stocks, the residual income model separates value as the sum of two components:

• The current book value of equity (BV)
• The present value of expected future residual income [sum from time t=1 to infinity(RI/(1+r)^t)]

The model can be used to value the firm (based on total book value and residual income) or a share, using book value and residual income per share.

Like any model, residual income models are more appropriate at some times than others. They are most appropriate when:

• The subject company is non-dividend paying
• Free cash flow is unstable or negative over a reasonable forecast horizon
• Other approaches result in greater sensitivity to terminal value than the investor finds comfortable

The are less appropriate when:

• the company’s accounting practices result in significant dirty surplus
• the components of residual income (book value, ROE) are not predictable

For more information, see all articles on: Accounting, Financial Statement Analysis, Investing in Stocks, Valuation

See also:

The Residual Income Valuation Model

Residual Income as Cash Flow

Strengths and Weaknesses of the Residual Income Model

Economic Value Added (EVA)

Residual Income