Hi guys… So far I can only see residual income as as a gay ass backwards version of the DDM… Now I am sure there is more to it, else CFAI would not have dedicated a chapter to the topic. Can someone give an example of a case where I would really want to use residual income? I know the book gives bullet points about when to use residual income, but it is just not connecting for me.
The big advantage is that you do not need to rely on the dividend policy, or any dividends whatsoever. You are evaluating the value of the FIRM here, not the stock price. If you can assume income over required earnings grows at a constant rate, g, (no crazy cash flows, just predictable excess forever), then the residual income model valuation is best. The reason it looks like DDM is because it’s assuming a perpetuity of the future excess cash flows. In DDM, if we assume the dividends don’t grow the value of the firm is just D*(1/k), where 1/k is the PV of cash flows factor (perpetuity) of required return. When we add growth factor (1+g) to the numerator, it acts like a offset to the discount, k, forever (in perpetuity). And you know that the math boils down to D/(k-g). So residual income says, i have my core book value (I know and trust), Bo. I also have another component the excess of required return I’m going to receive forever, that will grow at rate g. This component is like a franchise or economic profit over my book that I’m receiving. Now my firm value is my Book + PV(future excess over required returns in perpetuity) = Bo + [(ROE - k)*Bo]*[1/(r-g)]
Residual Income valuation is mostly used for measuring management efficiency, capital projects, and estimating executive compensation/bonuses.