Use of Residual Income Models

A company with positive residual income—generating more income than its cost of capital—is creating value. A company with negative residual income is destroying value. A higher residual income is associated with a higher valuation.

Residual income models have been used to value individual stocks and equity indices. The residual income model has also been used to measure the impairment of goodwill.

Residual income is also referred to as economic profit/abnormal earnings because of its estimate of the company’s profit after deducting the cost of all capital.

Question

Which of the following statements is the most accurate regarding residual income?

1. A company with positive residual income is generating more income than its cost of capital.
2. A company with positive residual income is only generating enough income to cover its cost of debt.
3. A company with positive residual income should expect its share price to be lower than its book value.

Solution

The correct answer is A. 

A company with positive residual income generates more income than its cost of capital for both debt and equity.  Residual income is calculated by deducting a company’s cost of capital. If it is positive, then the company is generating more income than its cost of both debt and equity.

B is incorrect. A company with positive residual income is generating enough income to cover both its cost of debt and cost of equity.

C is incorrect. A company with positive residual income should expect its share price to be higher than its book value because it is generating value.

Reading 26: Residual Income Valuation

LOS 26 (b) Describe the uses of residual income models.