Valuing a Company Using the Residual Income Formula
A company and its stock can be valued in a variety of ways. One way would be by juxtaposing the multiples and metrics of one company against those of other companies within its industry category or sector; what is known as the relative valuation approach. Another method would be to formulate a value based on an estimate of the company’s value, for example using the dividend discount method or cash flow modeling.
There is a more recent method of absolute valuation; the residual income method, which is largely unknown to most people other than analysts who frequently use the residual income formula to ascertain company value. This article’s purpose is to illustrate the principles upon which the residual income formula is based and how it can be used to determine the absolute value of a company.
Introduction to the Residual Income Formula
When the words “Residual Income” come to mind, it is often associated with surplus cash and money to burn. Although this may be an accurate association when looking over a personal finance plan, when it comes to discussing equity evaluation we refer to the income made by a company after taking into account the true cost of its capital as residual income.
This is where some clever folks start wondering if this is not already done by a company when they account for their capital’s cost in their routine interest expense reports. This is true in a way, but interest expenses as seen on the income statements only only account for the cost of a company’s debt, not including costs of equity like dividend payouts etc.
Another way to look at the cost of equity is to look at it as the required rate of return or the shareholder’s opportunity costs. What the residual income model attempts to provide are adjustments to the future earning estimates so as to compensate for equity costs and improve the precision of the value placed on a company.
Unlike the return to bondholders, the return to equity holders is not a legal obligation, if a company hopes to attract many investors they must offer some sort of compensation for investment risk exposure.
The most important calculation that factors into the equation that produces a business’s residual income is the equity charge. This can be produced by multiplying a company’s total equity capital by that equity’s required rate of return. the Equity charge can also be estimated with the capital asset pricing model.
This Formula below will show how to calculate the equity charge:
A = B x C
A – Equity Charge
B – Equity Capital
C – Cost of Equity
Once you have used that formula to determine the equity charge, this must be subtracted from the company’s net income. The difference will be the residual income.
As an example, let’s say that the X Company reports their last years earnings at $85,000 and has invested $750,000 worth of equity into its capital structure with 11% required rate of return.
The residual income formula would be:
First the Equity Charge:
$750,000 X .11 = $82,500
Net Income = $85,000
Minus the Equity Charge = $82,500
And the Residual Income is = $2,500
What do we see in this example above? By using the residual income formula we see that even though this X company has reported some nice profits in the last year when you subtract the costs, the return to shareholders, we see some very slim profit margins considering the given risk level. The residual income method can reveal an important factor when deciding the intrinsic value.
Findings like this is what encourages the use of this residual income method. There are many situations where a company may appear very successful based off accounting reports, yet when it is viewed from the perspective of a shareholder it can hardly be considered profitable if its not generating any residual income.
Finding the Intrinsic Value With Residual Income
Now that you have learned how to calculate the residual profits of a company you will have the tools to begin determining the intrinsic value of a company. In the same way that other absolute valuation methods are used in residual income modeling the idea of discounting future earnings can be applicable as well.
The intrinsic value of a company, also known as its fair value, can be separated into book value and present values of projected future residual incomes when using the residual income approach. You may have noticed that this residual income formula and its valuation applications are similar to the multi stage dividend discount model because it also substitutes any future dividend payments with expected future residual incomes.
The residual income method provides several advantages and drawbacks when you compare it with other more popular methods of determining the absolute value of a company, like DCF or dividend discount methods.
On the one hand, using the residual income model means that you will operate off of information that is readily available on the company’s financial statements and can also be applied to companies that don’t generate positive cash flow or pay dividends. Additionally, as we mentioned before the residual income models reflect more than just the company’s accounting profitability and shine a light on the actual economic profitability, which is more important from the shareholder’s view.
The biggest disadvantage of the residual income method is that it places so much stock in the ability to predict the future, inasmuch as it relies on estimates of a firm’s anticipated financial statements. This leaves predictions that are seriously affected by previous misrepresentations on a company’s financial statements, psychological bias etc.
This being said the residual income method of company valuation is in fact a very applicable method of making valuations and can even be practiced by rookie investors. When used in combination with other methods of company valuation, the residual income method can provide you with a clear insight into a company’s true intrinsic value.