Work out economic value added, market value added and residual income and explain what they mean
The idea
Residual income is net income less a charge for the equity capital used: RI = NI − r × beginning book value of equity, or equivalently (ROE − r) × beginning book value. It measures profit above what shareholders require. Economic value added applies the same idea to the whole firm: EVA = NOPAT − WACC × invested capital, where NOPAT is EBIT × (1 − t). Market value added is the market value of the company less the capital invested in it, and in theory equals the present value of future EVA. A company with positive net income can still have negative residual income. The traps are charging for capital on ending book value and deducting interest twice in EVA.
In the app: 3 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Residual Income Valuation
- Explain what residual income models are used for
- Value a common share with the residual income model and contrast when value is recognised under it and under other present value models
- Explain the fundamentals that determine residual income
- Explain how residual income valuation links to the justified P/B ratio derived from forecasted fundamentals
- Work out a common share's intrinsic value with residual income models that have one constant-growth stage or several stages, and explain the result
- Back out the growth rate implied in residual income from the market P/B ratio and an estimated required return on equity
- Explain continuing residual income and defend an estimate of it at the forecast horizon in light of the firm's and industry's outlook
- Contrast residual income models with free cash flow and dividend discount models
- Explain where residual income models are strong and weak and argue for using one to value a firm's common stock
- Set out the accounting problems that arise when residual income models are applied