Residual Income Formula – Modern Finance Explained

Residual income (RI) is a financial metric that measures the amount of profit that a company generates in excess of its required rate of return. It is calculated by subtracting the required rate of return multiplied by the company’s average operating assets from its operating income.

The residual income formula is as follows:

Residual Income = Operating Income – (Required Rate of Return * Average Operating Assets)

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The residual income valuation model values a company as the sum of book value and the present value of expected future residual income. Residual income in this case is the economic profit remaining after the deduction of opportunity costs for all sources of capital.

Residual income is calculated as net income less a charge for the cost of capital. This is known as the equity charge and is calculated as the value of equity capital multiplied by the cost of equity or the required rate of return on equity.

The formula is:

Residual Income = Net Income – Equity Charge

Other types of residual income

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Personal finances residual income: This is the type of residual income that individuals earn from passive sources, such as rental income, stock dividends, or royalties.

Corporate residual income: This is the type of residual income that businesses earn from ongoing operations after deducting all expenses, including the cost of equity capital.It is also considered the company’s net operating income or the amount of profit that exceeds its required rate of return.

Residual Income Formula – Why is it important?

In calculating residual income models, equity is used to value shares. But the cost of equity is not directly stated in the financial statements. This is important information that potential investors must learn to calculate. 

The cost of equity is the cost companies incur in keeping shareholders glued to their shares. By investing in shares of a company, shareholders take risks

These shareholders expect to be compensated for the risk they take. Good companies are very sensitive to this shareholder requirement. They sincerely believe in the concept of providing risk compensation to its shareholders in the long term.

If this is not done, why will people buy their assets?

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It will be better to purchase a bank deposit or bonds where the risk of loss is much lower. Of course, shareholder risk compensation cannot be practiced until the company itself is doing good business.

So, to take care of shareholders, the company must first take care of itself. This means that to adequately compensate shareholders, the company is not required to do anything out of the box. When the company grows, shareholders benefit too. So in a residual income formula, the cost of equity is a very important part.

What should the cost of equity be? More than the prevailing risk-free rate, investors invest in stocks. They do it when they have the option of investing in a fixed deposit, why? For higher yields.

For a company, the cost of equity cannot therefore be too low. This will make them less preferable. Cost of equity = equity (net worth) x expected returns. By maintaining a higher cost of equity, companies continue to attract investors to their shares. A higher cost of capital means more stock trading. More trading means higher trading volumes. 

High volume stocks are more likely to become popular and gain market value (market capitalization). Increasing market capitalization not only helps investors, but also helps the underlying company. Increasing capital on the stock market becomes easier.

Residual income formula – what does it mean for investors

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A company with higher residual income should be the preferred choice of investors. When two companies have the same net profit, investors’ choice will be the one with higher residual income. One of the costs of equity is the payment of dividends to shareholders. The dividend is paid on both preferred and stock shares. We know that in the cost of equity we have a component called “expected returns.” Investors can earn returns in two ways:

a) by dividends, and

(b) through capital appreciation.

Expected returns = Dividend + Market price appreciation

A for-profit company can guarantee both dividend payments and price appreciation to its shareholders. Corporate profits are shown in income statements as net income. Dividends generated by shareholders occur immediately as soon as the company (varies from company to company) generates reasonable net profit.

But market price appreciation takes time.

The majority of shareholder returns come from price appreciation. And that’s where shareholders are supposed to wait to see returns materialize.

But where is the residual income?

Residual income = Net profit – Cost of equity

= Net profit – [Net worth x expected returns]

= Net profit – [Cost of paying dividend + Cost of guaranteeing capital appreciation]

What does this formula mean?

The company pays dividends and also provides capital appreciation.

But doing this comes at a huge cost to the business.

A company that still has money in its pocket after ensuring the cost of equity is good for investing. For what?

Because these are the companies that make amounts of money for their shareholders and for themselves. After taking care of shareholder interests, if some residual income remains, that’s a huge indicator that the company is likely to repeat (or even better) performance next year. Investors should therefore always look for companies with substantial residual income. Companies showing only positive net profit are not enough.

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