just started out residual income valuation model . seems to be straight forward , but one thing i am unable to wrap my head around is the fomrula for RI .
i.,e RI = NI - Equity Charge .
but in the in another formula , it says :
RI = Eps - (R*BV of previous year) … why are we using previous year BV ?
and secdonly , it also states that in RI valuation model the value of the stock is recognised earlier than DDM or FCF model . how is that ?
Can someone shed some light on the above 2 points ?
what is creating the residual income for you? Previous year’s Book Value - earns a return on Interest. (ROI)
This year’s EPS is greater than that amount --> that is extra (residual) income.
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in the normal DDM/FCF models - this extra amount is not recognized. You have Dividends - which is the income from your shares or the free cash flow alone getting discounted to PV terms - and that becomes your share value. Here the extra income is recognized.
Firstly. Previous year ending book value = this year’s beginning book value. We want to know how much our actual income during this year compares to “how much we expected given our net assets beginning of the year” Secondly, FCF models use a concept called “terminal value”, which is an assumed value sometime far in the future and it carries most of the weight in the FCF model. SO FCF relies on the accuracy of this dodgy figure bu RI uses a book value approch which is quite conservative.
This isn’t to say RI is better than FCF or DDM. It is just one observation. There are disadvantages to RI too.