CFA® Level II · Equities · free lesson

Residual Income Valuation

Residual income models value a company as its book value plus the present value of the profits it earns above the cost of equity, linking valuation directly to the question every investor should ask: does this company earn more than its capital costs? This module calculates residual income, EVA and MVA, builds single-stage and multistage models, relates them to justified P/B, infers growth from market prices, models fading excess returns with a persistence factor, and reviews the accounting adjustments the approach requires. It is especially relevant for banks and for companies without dividends or positive free cash flow.

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What you will learn

1. Calculate residual income, economic value added and market value added, and explain why residual income models are used.

RI = net income - r x beginning book value = (ROE - r) x beginning book value.
EVA = NOPAT - WACC x total capital; NOPAT = EBIT(1 - t), so interest is not deducted twice.
MVA = market value of the company - capital invested, and equals the PV of expected EVA.
Positive RI requires ROE above the cost of equity; profit alone is not value creation.
RI models suit non-payers and negative-FCF companies, rely less on terminal value, but need reliable, clean-surplus accounting.

2. Value a share with single-stage and multistage residual income models and relate residual income to the justified P/B ratio.

V0 = B0 + PV of expected RI; project book value with clean surplus: B_t = B_(t-1) + E_t - D_t.
Single stage: V0 = B0 + (ROE - r)B0/(r - g); justified P/B = (ROE - g)/(r - g).
ROE = r implies value = book; ROE < r implies a discount to book.
Multistage: explicit RI, then constant, growing, fading RI or a horizon P/B premium (P_T - B_T).
RI and DDM give the same value with consistent assumptions; RI recognises value earlier.

3. Estimate the growth rate implied by a market P/B and justify a continuing residual income assumption using a persistence factor.

Implied growth: g = r - B0(ROE - r)/(P0 - B0); compare with plausible long-run growth.
Persistence factor omega (0 to 1): each year's RI after T is omega times the previous year's.
Final term = RI_T / [(1 + r - omega)(1 + r)^(T-1)]; omega = 0 stops RI, omega = 1 makes it perpetual.
Higher omega: low payout, durable advantages, persistent industry returns.
Lower omega: extreme ROE, large special items and large accruals.

4. Compare residual income with dividend and free cash flow models, and identify the accounting adjustments needed to apply residual income valuation.

RI recognises value earlier than DDM or FCF models, so terminal value matters less.
Best when dividends are absent or unpredictable, FCF is negative or terminal value is very uncertain.
Clean surplus violations (OCI items) require forecasting with comprehensive income.
Adjust book value for fair value gaps, expensed intangibles and off-balance-sheet items.
Remove non-recurring items and watch for aggressive accounting and cross-border differences.

Module at a glance

RI = earnings - r x beginning book value; positive only when ROE exceeds the cost of equity.
EVA = NOPAT - WACC x capital; MVA = market value - capital and equals the PV of future EVA.
V0 = B0 + PV of RI; single stage: B0 + (ROE - r)B0/(r - g); justified P/B = (ROE - g)/(r - g).
Project book value with clean surplus: B_t = B_(t-1) + E_t - D_t.
Implied growth: g = r - B0(ROE - r)/(P0 - B0).
Persistence: final term RI_T/[(1 + r - omega)(1 + r)^(T-1)]; low omega for extreme ROE, special items and accruals.
Adjust for OCI items (use comprehensive income), non-recurring items, off-balance-sheet items and fair value gaps.

This free module has 4 lessons, 16 practice questions with full explanations.

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