The residual income model is one of several income models used for equity valuation that measures how much economic profit a company earns above its costs of capital.
Unlike the dividend discount model DDM, which only works for firms that pay dividends, the residual income model can value any company with clear book value of equity and earnings data.
This valuation model starts with the current book value of equity and adds the present value of future residual incomes, where each period's residual income equals net income minus the equity charge equity capital demands.
The charge equity capital represents the opportunity cost of holding shares rather than investing elsewhere.
The formula for residual income takes the net income from the income statement and subtracts the equity costs, which equal the book value of equity times the required rate of return.
When a firm earns more than its equity costs, it creates positive economic profit and adds value for shareholders.
When earnings fall below this threshold, the company destroys value even if it demonstrates positive net income on its income statement.
This focus on true economic profit rather than accounting profit makes the residual income approach one of the most useful valuation methods for finding stocks that truly create wealth.
Compared to discounted cash flow DCF models that rely on free cash flow projections, the residual income model ties more closely to accounting data that investors can verify.
Free cash flow figures can be harder to forecast because they depend on capital spending plans that may shift from year to year.
The residual income model instead uses earnings and book values that appear directly on financial statements, making it easier to check the inputs.
Both valuation methods aim to find the same fair value, but they get there through different paths and may provide different results when assumptions do not line up.
The interest expense a company pays on debt does not factor into residual income at the equity level, since the model focuses only on the returns left for shareholders after covering all equity costs.
This makes it different from economic value added, which looks at returns for all capital providers including debt holders.
The required rate of return plays a key role as the hurdle rate that earnings must beat.
Setting this rate too low will make most stocks look cheap, while setting it too high will make them all look too expensive.
Value investors use the residual income model as a strong check against other valuation methods like the dividend discount model DDM and discounted cash flow DCF approaches.
Companies that demonstrate positive present value of future residual incomes over many years tend to have durable competitive edges that protect their economic profit from fading away.
This model works well for banks and financial firms where book value of equity closely tracks true asset values.
Pairing it with other equity valuation tools provides a fuller picture of what any stock should truly be worth in the long run.