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 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 * Cost of Equity)

Example: If a company has a net income of $500,000, equity capital of $2,000,000, and a 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.