101 Concepts for the Level I Exam

Essential Concept 57: Residual Income Model

According to the residual income model, the intrinsic value of equity is a sum of two components:

The current book value of equity
The present value of expected future residual income

There are three ways to express the value of a stock under this model:

$\mathrm{V}}_0\mathrm{=}{\mathrm{B}}_0\mathrm{ +}{\sum\limits_{t=1}^{\infty}}{\frac{\mathrm{R}{\mathrm{I}}_{\mathrm{t}}}{{\left(\mathrm{1+r}\right)}^{\mathrm{t}}}}$

$\mathrm{V}}_0\mathrm{=}{\mathrm{B}}_0\mathrm{+ }{\sum\limits_{t=1}^{\infty}}{\frac{\left({\mathrm{E}}_{\mathrm{t}}\mathrm{-}\mathrm{r}{\mathrm{B}}_{\mathrm{t-1}}\right)}{{\left(\mathrm{1+r}\right)}^{\mathrm{t}}}}$

$\mathrm{V}}_0\mathrm{=}{\mathrm{B}}_0\mathrm{+}{\sum\limits_{t=1}^{\infty}}{\frac{\left(\mathrm{RO}{\mathrm{E}}_{\mathrm{t}}\mathrm{-}\mathrm{r}\right){\mathrm{B}}_{\mathrm{t-1}}}{{\left(\mathrm{1+r}\right)}^{\mathrm{t}}}}$

As compared to the DDM and FCFE/FCFF models, residual income models are less sensitive to terminal value estimates. This is because, RI models include the company’s current book value which usually represents a large portion of the estimated intrinsic value.