it says residual income is excess of net income over book value of assets x return on equity…
shouldnt it be market value of equity because thats what investors had to pay and want the return to be earned on?
I think your statement should read: “it says residual income is excess of net income over book value of assets x COST OF EQUITY…” via RI = NI - ®(Previous BV). The other RI calculation is RI = (ROE - R)(Previous BV), to which your statement should read something like “it says residual income is the excess of ROE over r multiplied by the previous bookd value”
I’m not sure what you mean by “shouldnt it be market value of equity because thats what investors had to pay and want the return to be earned on?” - are we talking about Residual Income (value generated by firm) or are we talking about cost of equity (required return by investor)?
ok let me rephrase it this way
you bought stocks of a company for $50 whose Book value is $20. required return on equity being 10%
now the company generated $10 of net income/share over the year.
since u bought the share at $50 and have a required rate of return of 10% the residual income company generated for you is 10-50(10) i.e $5 but the cfai module says u use book value of the share so according to them your residual income is 10-20(10) i.e $2, which seems a bit flawed because your required rate of return is on the market price you paid not the book value
Ok, so this $50 is an overvalued stock… or maybe the cost of equity is too high based on poor sample to generate beta… or there was not a clean surplus…etc, there are so many other variables. But theoretically, unless the firm can continuously generate ROE more than 10%, such that the PV of this excess plus the BV will be > $50, and that price conversion would take place, this was a poor investment. I would suggest not to just look at one sentence by itself and try to proof the formula. It’ll confuse the heck out of you.
The underlying idea is that investors require a rate of return from their resources – i.e. equity – under the control of the firm’s management, compensating them for their opportunity cost and accounting for the level of risk resulting.If a company went belly-up and sold all of its assets and subtracted any liabilities, the remaining value investors would receive represents the company’s book value. In other words, the book value represents the total value of all the assets minus any liabilities. This value often gets referred to as shareholders’ equity or owners’ equity. Book value really ties into how accountants value the company on a per-share basis and has nothing to do with how the market values the company’s stock.The market value of a stock represents the price investors will pay to buy or sell the security. Market value does not always represent the actual value of the company. The terms “overvalued” and “undervalued” compare the market value of a company’s stock to the company’s actual value, or book value.
It is based on book value because that is the value of assets that the company utilized in that year to generate net income. Market value incorporates expectations of future growth, which could overstate the value of assets that the company has available for use in this period. Consider a stock like Facebook that trades at ~50x earnings. This is based on assumptions of future growth, but the book value of assets is what Facebook uses to generate net income this year.
Keep in mind that residual income is not a measure of investment return from the investor’s perspective, so it is irrelevant what price an investor paid for the stock.