There are sundry different methods to valuing a company or its stock. One could opt to use a relative valuation approach, comparing multiples and metrics of a undeviating in relation to other companies within its industry or sector. Another alternative would be valuing a firm based upon an downright estimate, such as implementing discounted cash flow modeling or the dividend discount method, in an attempt to place an constitutional value to said firm.
An Introduction to Residual Income
When most hear the term residual income, they about of excess cash or disposable income. Although that definition is correct in the scope of personal finance, in terms of even-handedness valuation residual income is the income generated by a firm after accounting for the true cost of its capital. You might be bid, “but don’t companies already account for their cost of capital in their interest expense?” Yes and no. Interest expense on the income announcement only accounts for a firm’s cost of its debt, ignoring its cost of equity, such as dividend payouts and other right-mindedness costs. Looking at the cost of equity another way, think of it as the shareholders’ opportunity cost, or the required rate of return. The remaining income model attempts to adjust a firm’s future earnings estimates to compensate for the equity cost and place a more conscientious value to a firm. Although the return to equity holders is not a legal requirement, like the return to bondholders, in order to captivate investors firms must compensate them for the investment risk exposure.
In calculating a firm’s residual income, the key answer is to determine its equity charge. Equity charge is simply a firm’s total equity capital multiplied by the required in any event of return of that equity, and can be estimated using the capital asset pricing model. The formula below shows the tolerance charge equation:
Equity Charge = Equity Capital x Cost of Equity
Once we have calculated the equity burden, we only have to subtract it from the firm’s net income to come up with its residual income. For example, if Company X probed earnings of $100,000 last year and financed its capital structure with $950,000 worth of equity at a required type of return of 11%, its residual income would be:
Equity Charge – $950,000 x 0.11 = $104,500
So as you can see from the above example, using the concept of residual income, although Company X is reporting a profit on its income account, once its cost of equity is included in relation to its return to shareholders, it is actually economically unprofitable based on the given wreck of risk. This finding is the primary driver behind the use of the residual income method. A scenario where a company is well-paid on an accounting basis, may still not be a profitable venture from a shareholder’s perspective if it cannot generate residual income.
Valuing A Attendance Using The Residual Income Method
Intrinsic Value With Residual Income
Now that we’ve found how to compute extra income, we must now use this information to formulate a true value estimate for a firm. Like other absolute valuation ways, the concept of discounting future earnings is put to use in residual income modeling as well. The intrinsic, or fair value, of a company’s store up using the residual income approach, can be broken down into its book value and the present values of its expected coming residual incomes, as illustrated in the formula below.
As you may have noticed, the residual income valuation formula is very correspond to to a multistage dividend discount model, substituting future dividend payments for future residual earnings. Using the yet basic principles as a dividend discount model to calculate future residual earnings, we can derive an intrinsic value for a immovable’s stock. In contrast to the DCF approach which uses the weighted average cost of capital for the discount rate, the appropriate upbraid for the residual income strategy is the cost of equity. (Learn the strengths and weaknesses of passive and active management when annoying to uncover the overall market’s worth. Check out Strategies For Determining The Market’s True Worth.)
The Bottom Line
The spare income approach offers both positives and negatives when compared to the more often used dividend reduction and DCF methods. On the plus side, residual income models make use of data readily available from a firm’s fiscal statements and can be used well with firms who do not pay dividends or do not generate positive free cash flow. Most importantly, as we argued earlier, residual income models look at the economic profitability of a firm rather than just its accounting profitability. The heftiest drawback of the residual income method is the fact that it relies so heavily on
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