Residual Income Valuation Model

Residual income models esteem has become a generally perceived approach in the practice of
both investment and research. Thoughtfully, the residual fund is net income less a charge for
equity investors' opportunity cost in producing total income. It is the leftover or remaining
income after consideration of all the expenses of the organization's capital. The appeal of
residual pay models originates from the adequacy of conventional bookkeeping. In particular, an
organization's pay proclamation incorporates a charge for the expense of obligation capital as
interest cost, it does exclude a charge for the expense of equity capital. An organization can have
positive net profit however may in any case not be adding value for investors in the event that it
doesn't procure more than its expense of equity capital. Residual income models expressly
perceive the expenses of all the capital utilized in the generation of income. (CFA Institute,
2022)
Residual Income = Net Income- Equity capital* Cost of equity
Strengths
 It allocates less weight to the terminal value
 Can be used on the readily available accounting information
 The companies that do not have any positive near term free cash flows expected,
companies that do not pay dividends, and the companies whose cash flows are not
predictable can also be valued. (IFT, 2022)
Weaknesses
 The model uses accounting information that has high manipulation risk.
 The accounting data may need to be adjusted.
 The model makes the assumption that the clean surplus relation holds.
 The model also makes the assumption that the cost of debt equals the expense of interest.
(IFT, 2022)
The abnormal Earnings growth model
The abnormal earnings growth model is an accounting and finance model which evaluates the
financial status of an organization. This model helps in determining the equity value of the
company based on the book value and earnings. The evaluation of the financial position of a
company requires that the income and the revenue of the company must be taken into account.
The model measures whether the net asset value of the company in relation to the decision of the
management has a positive impact on the financial status of the company or not. If the earrings
or the income of the company is higher than expected, the investor would be willing to pay
higher than the book value and if the earnings have not achieved the same the investors would
not be willing to pay more than the book value. Therefore, this model helps the researchers and
the investors to find the potential fair value of the share. (CFI, 2022)
Value of the stock = Book Value + Perpetual Value if Future Expected Residual Income
Strengths
 The model is well aligned with the analysts’’ forecasts.
 It shows the management quality and incorporates the financial statements in the
analysis.
 It also focuses on maximizing the wealth of the shareholders. (CFI, 2022)
Weaknesses
 The adjustments in the accounting figures can lead to incorrect book value.
 The companies paying consistent dividends cannot be valued suitably.
 It is highly dependent on futuristic forecasts and business projections.
 The forecasting issues can lead to incorrect valuation. (CFI, 2022)
Sensitivity of the two
The abnormal earnings growth model is without a doubt more delicate to the required rate of
return or the discount rate when contrasted with the residual income valuation model. The
justification behind the equivalent is the way that in the previous, a significant part of the
underlying asset’s value (the one being esteemed) is contributed by the present value of the
terminal worth of the asset’s cash flows. This basically suggests that a significant piece of the
asset's worth is caught in the cash flows of the future, consequently making the impact of the
discounted cash flows significant in the valuation of the asset. Notwithstanding, in the residual
income valuation model, a significant piece of the asset’s worth is caught by its current book
value of equity. This suggests that the future cash flows of the residual income have less impact
on the estimation of the asset’s current value, consequently delivering the limiting effect of the
required rate of return moderately irrelevant. Therefore, it can be simply said that both the
methods almost have the same inputs, but one is more influenced by the current book value and
the other is more impacted by future residual values. 
Empirical evidence
Residual income valuation model 
One of the studies analysed the value investment strategy based on the residual income valuation
approach and calculated the price-value ratio using the same approach. The study used the data
from the German companies from the period 1990 to 2002. The study found that undervalued
companies generate higher returns. This result was statistically weak and stated that the model
does not work significantly better than the simple ratio valuations. (Jamin, 2008)
Another study used the residual income valuation model to test whether it can explain the
movement of the stock prices in Taiwan. The result stated that the residual income valuation
model is successful in explaining the movements in the stock price. Therefore, the investors can
take full advantage of this model to predict future stock prices and earn better returns. (Ke-Shin
& Chen-Yin, 2019)
The abnormal Earnings Growth model
A study took around 3,994 firms between 1984 to 2003 to fund the justification of the
performance of the model. And has found that the abnormal earnings model underperforms the
relative income valuation model in terms of accuracy. (Yoo, 2005)
Another study tried to realise the impact of conservative accounting on the abnormal earning
growth model and residual income valuation model. The study has found that the abnormal
earnings growth model has more potential to handle more conservative and biased earnings in
comparison to the residual income approach. Secondly, the study found that the persistence of
the residual income valuation model is understated and the persistence of the abnormal earning
growth model is overstated. (Skogsvik & Nauroth, 2013)
References
CFA Institute (2022). Residual Income Valuation. [Online]
Available at: https://www.cfainstitute.org/en/membership/professional-development/refresher-
readings/residual-income-valuation [Accessed 29 May 2022].

CFI (20220. Abnormal Earnings Valuation. [Online]

IFT (2022). Essestial Concept 59: Strengths and Weaknesses of Residual Income Models.
[Online]
Available at: https://ift.world/concept1/level-ii-concept-59-strengths-and-weaknesses-of-
residual-income-models/ [Accessed 29 May 2022].

Jamin, G. ( 2008). Investment Performance of Residual Income Valuation Models on the

Ke-Shin, T. & Chen-Yin, K. (2019). Can Residual Income Model Explain Taiwan's Stock Price
Movement? Evidence from VAR-based Cross Equation Restriction Test. The Empirical
Economics Letters, 8(10), pp. 1011-1020.

Skogsvik, K. & Nauroth, B. E. J. (2013). A note on accounting conservatism in residual income

Yoo, Y. K. (2005). An Empirical Assessment. Working Paper, pp. 1-21.