Residual Income Model
The Residual Income Model is a valuation method that calculates the Intrinsic Value of a company based on its expected future Residual Income, which is the Net Income generated after deducting the Equity/">Cost of Equity Capital. This model helps assess whether a Stock is overvalued or undervalued compared to its current market price.
Formula: Residual Income = Net Income – (Equity Capital * Equity/">Cost of Equity)
Example: If a company has a Net Income of $500,000, Equity Capital of $2,000,000, and a Equity/">Cost of Equity of 10%, the Residual Income would be:
- Residual Income = $500,000 – ($2,000,000 * 10%) = $500,000 – $200,000 = $300,000
Cases: In a situation where a company generates consistent Residual Income over several years, it may be considered a good investment. Conversely, if a company’s Residual Income is consistently negative, it may signal poor performance and potential risks for investors.