Fundamental Determinants of Residual Income

The fundamental drivers of residual income can be recognized by assuming a constant growth in dividends and earnings.

Assuming constant growth, a stock’s intrinsic value under the residual income model, can be expressed as:

$$\text{V}_{0}=\text{B}_{0}+\frac{\text{ROE}-\text{r}}{\text{r}-\text{g}}\text{B}_{0}$$

If the return on equity equals the required return on equity, the share’s intrinsic value will be equal to the book value. If the return on equity is greater than the required return on equity, the stock’s intrinsic value will be higher than the book value, and the justified P/B ratio will be greater than 1. If the return on equity is less than the required return on equity, the stock’s intrinsic value will be less than the book value, and the justified P/B ratio will be less than 1.

Question

Which of the following is least likely a fundamental driver of residual income?

1. Constant growth in earnings.
2. Constant growth in revenues.
3. Constant growth in dividends.

Solution

The correct answer is B. 

Constant growth in revenues is not a fundamental driver of residual income.

A is incorrect. Constant growth in earnings is a fundamental driver of residual income.

C is incorrect. Constant growth in revenues is a fundamental driver of residual income.

Reading 26: Residual Income Valuation

LOS 26 (l) Evaluate whether a stock is overvalued, fairly valued, or undervalued based on a residual income model.