The residual income model attempts to adjust a firm's future earnings estimates, to compensate for the equity cost and place a more accurate value to a firm. In calculating a firm's residual income the key calculation is to determine its equity charge. Equity charge is simply a firm's total equity capital multiplied by the required rate of return of that equity, can be estimated using the capital asset pricing model. Equity Charge = Equity Capital x Cost of Equity. Once we have calculated the equity charge, we only have to subtract it from the firm's net income to come up its residual income. The intrinsic, or fair value, of a company's stock using a the residual income approach can be broken down into its book value and the present values of its expected future residual incomes, as illustrated in the formula below.
The residual income approach offers both positives and negatives when compared to the more often used dividend discount and DCF methods. On the plus side, residual income models make use of data readily available from a firm's financial 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 discussed earlier, residual income models look at the economic profitability of a firm rather than just its accounting profitability. The biggest drawback of the residual income method is the fact that it relies so heavily on forward looking estimates of a firm's financial statements, leaving forecasts vulnerable to psychological biases or historic misrepresentation of a firms financial statements.
All that being said, the residual income valuation approach is a viable and increasingly popular method of valuation and can be implemented rather easily by even novice investors. When used alongside the other popular valuation approaches, residual income valuation can give you a clearer estimate of what the true intrinsic value of a firm may be.
