Residual income valuations make use of readily available data and consider an organization’s economic profitability rather than accounting profits, providing an invaluable means of placing value on growing companies that do not yet generate free cash flow or pay dividends.
Residual income valuations present one of the greatest challenges, given their highly volatile past earnings history. One of the key steps is estimating future earnings growth rates.
Theory
Residual income refers to profits after subtracting charges representing the cost of capital applied to equity invested in the business, which includes equity, debt and preferred shares found on its balance sheet. Residual income differs from Economic Value Added (EVA), which offers a more holistic picture of firm value creation by taking into account costs and returns of all providers of capital – from debt holders to preferred shareholders.
One of the greatest difficulties associated with residual income valuation is establishing its cost of equity, which can be done by using models such as CAPM to establish its required rate of return or by employing other approaches such as growth modeling. Estimating growth rates for future residual income may prove more challenging due to diminishing returns over time; one solution to this difficulty could be using multistage residual income approach with explicit forecast periods and terminal values at each end of that forecast period.
Methods
The residual income valuation method offers an ideal alternative to dividend discount model (DDM) and discounted cash flow (DCF) methods for companies that do not pay dividends or generate free cash flow. Its greatest utility lies in being suitable for companies without dividend payments or free cash flows.
However, residual income valuation can present some unique difficulties. One such challenge lies in its focus on aggregate returns which could cause it to overestimate value because, unlike residual income growth in most cases, this does not translate into profit or cash flow growth.
Estimating the cost of equity capital can be challenging, requiring different approaches for each method used to do it. Consistency between calculations is vital: for instance, leaving out amortisation of purchased intangible assets from calculations while including them when investing capital could result in an inaccurate valuation – especially if amortisation accounts for earnings rather than cost of equity capital.
Applicability
Residual income valuation is a viable and popular method for estimating intrinsic value, often used alongside other valuation approaches like dividend discount model or discounted cash flow (DCF). However, its use may be restricted due to forecasts being inherently uncertain, making this valuation approach inapplicable for industries or companies experiencing major restructuring processes.
Residual income models are particularly useful for companies that do not pay dividends or have unpredictable dividend patterns, as it helps identify mean reversion in accounting profitability. Economic Value Added (EVA), another approach, takes a broader view of company value creation by considering all capital providers including debt and preferred shareholders; it may have less relevance for common stockholders, however, and may have less of an effect on book value per share than residual income valuation models alone; it is therefore best used in combination.
Limitations
Residual income valuation models can be very useful, yet they still come with certain limitations. Forecasts made with educated judgment and estimation may lead to errors due to misjudging future costs or market fluctuations that cause mistakes in estimates.
The residual method may also be misleading if aggregate returns are used as an approximate proxy for profit or cash flow, leading to an inaccurate sense of realism that fails to account for how aggregate returns might change over time.
Residual income valuation provides an alternative approach to DCF models, yet isn’t the only model used for company valuation. Other methods, like economic value added (EVA), may provide more comprehensive views of an organization’s performance than just residual income valuation alone can. EVA measures can help avoid forecasting accounting profitability problems while making assumptions incorrectly about your company.