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Residual Income Model

In short

Values a stock as book value plus the profit earned above the cost of equity

Say you put $1,000 of your own money into a business and expect at least 10% ($100/year) for the risk you're taking. If it earns $150, the extra $50 is residual income — profit beyond what you required. This model values a company as what's already invested plus all that extra profit, discounted to today.

The Residual Income Model starts from book value of equity and adds the present value of future residual income — net income minus an equity charge (cost of equity × book value). A company only creates value when ROE exceeds its cost of equity; one that never clears the hurdle is worth no more than book value. Because it anchors on the balance sheet rather than dividends or free cash flow, it suits banks and other financials where those flows are hard to define.

Formula

Value = Book Value + Σ RI_t ÷ (1 + r)^t, where RI = Net Income − (Cost of Equity × Book Value)

Related concepts

  • DCF Model — Imagine a friend promises to pay you $100/year for 10 years. Would you pay $1,000 today? Not quite — money tomorrow is worth less than money today. DCF calculates what future cash flows are worth right now.
  • Dividend Discount Model — If a stock pays $2/year in dividends, that payment is expected to keep growing at 3% a year, and you want a 10% return, the Gordon Growth version of DDM values it at $2 ÷ (0.10 − 0.03) ≈ $29. It's like valuing a bond off its coupon, but for a growing dividend.
  • Earnings Power Value — EPV asks a simple question: if this company never grew again, what would it be worth based on the profits it makes today? Assuming zero growth gives a conservative 'floor' value — anything the market pays above it is paying for future growth.
  • Return on Equity (ROE) — If you invest $100 in a business and it earns $20 profit, ROE is 20%. Higher means the company is better at making money with your investment.