Residual Income Valuation

For informational and educational purposes only • Not investment advice.

Compare Residual Income values across companies

Nvidia

Estimated Fair Value$732.56

Current Stock Price$229.28

Book Value Per Share$9.46

Selected ROE132.5%

Cost of Equity15.3%

ROE Spread117.1%

Detailed valuation

Apple

Estimated Fair Value$1,374.93

Current Stock Price$336.64

Book Value Per Share$7.32

Selected ROE160.1%

Cost of Equity10.5%

ROE Spread149.6%

Detailed valuation

Alphabet

Estimated Fair Value$186.85

Current Stock Price$351.66

Book Value Per Share$52.86

Selected ROE34.1%

Cost of Equity10.9%

ROE Spread23.2%

Detailed valuation

Microsoft

Estimated Fair Value$270.23

Current Stock Price$535.07

Book Value Per Share$59.55

Selected ROE42.5%

Cost of Equity10.3%

ROE Spread32.3%

Detailed valuation

Selected ROE

Time Horizon

Equity Risk Premium

Range: 2–10%

What is Residual Income Valuation?

Residual Income Valuation is based on the idea that a company creates value when it generates returns above the level required by its shareholders. This additional value is referred to as Residual Income.

When Return on Equity (ROE) exceeds the Cost of Equity, the company generates positive Residual Income and creates value beyond its existing Book Value. When ROE is below the Cost of Equity, Residual Income is negative.

The model uses Book Value and future Residual Income to estimate the company's intrinsic value. Unlike a Discounted Cash Flow model, it focuses on accounting earnings and Book Value rather than Free Cash Flow.

Residual Income Formulas

Required Shareholder Earnings

\text{Required Shareholder Earnings} = \text{Book Value per Share} \times \text{Cost of Equity}

Residual Income

\text{Residual Income} = \text{Forecast EPS} - \text{Required Shareholder Earnings}

Terminal Value

\text{Terminal Value} = \frac{ \text{Terminal Residual Income} }{ \text{Cost of Equity} - \text{Terminal Growth} }

Fair Value per Share

\text{Fair Value per Share} = \text{Book Value per Share} + PV(\text{Forecast Residual Income}) + PV(\text{Terminal Value})

How the Residual Income Model Works

The Residual Income model starts with today's book value per share, estimates future economic profit by forecasting returns on equity above the Cost of Equity, discounts those future residual income streams to present value, adds a terminal value, and combines everything into an intrinsic value per share.

Book Value Per Share

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Estimate Return on Equity ROE

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Forecast Book Value & Residual Income

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Discount Residual Income

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Terminal Value

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Combine Values

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Fair Value Per Share

Key Model Assumptions

• Book Value per Share represents the current equity attributable to shareholders.
• Current EPS uses trailing twelve-month (TTM) earnings when available, with the latest annual EPS used as a fallback when calculating current ROE.
• Normalized ROE is based on the median of up to the five most recent valid historical ROEs and is adjusted using the selected ROE scenario.
• Forecast ROE gradually converges toward the Terminal ROE over the forecast period.
• Book Value grows through retained earnings based on the selected Payout Ratio.
• Positive Residual Income is created when forecast earnings exceed the required earnings implied by the Cost of Equity.
• Future Residual Income is discounted using the Cost of Equity.
• The Risk-Free Rate is based on the U.S. 10-Year Treasury yield published by the Federal Reserve Board.
• Terminal Value is included only when final-year Residual Income is positive.

Step 1 — Start With Book Value

Book Value per Share = Total Shareholders' Equity / Shares Outstanding

Residual Income Valuation begins with the company's current Book Value per Share, representing the accounting value of shareholders' equity attributable to each share.

Step 2 — Estimate Return on Equity (ROE)

Current ROE = Earnings per Share / Book Value per Share

Normalized ROE = Median of Up to the 5 Most Recent Valid Historical ROEs

Selected ROE = Normalized ROE × Selected ROE Scenario

Terminal ROE = Cost of Equity + 1%
when Selected ROE exceeds the Cost of Equity

Otherwise, Terminal ROE = Cost of Equity

Current ROE measures earnings in relation to Book Value per Share, using trailing twelve-month (TTM) EPS when available and the latest annual EPS as a fallback. To reduce the effect of temporary fluctuations, the model estimates a Normalized ROE based on the median of up to the five most recent valid historical ROEs.

The selected ROE scenario adjusts Normalized ROE to determine the starting ROE used in the forecast. Forecast ROE then gradually converges toward the Terminal ROE.

When Selected ROE exceeds the Cost of Equity, Terminal ROE is set to the Cost of Equity plus 1 percentage point. Otherwise, Terminal ROE equals the Cost of Equity.

Step 3 — Calculate the Cost of Equity

Cost of Equity = Risk-Free Rate + Beta × Equity Risk Premium

The Cost of Equity represents the return shareholders require for investing in the company and is estimated using CAPM.

Positive Residual Income is created when forecast earnings exceed the required earnings implied by the Cost of Equity.

Step 4 — Forecast Book Value and Residual Income

Forecast EPS = Forecast ROE × Beginning Book Value per Share

Retained Earnings per Share = Forecast EPS × (1 − Payout Ratio)

Ending Book Value per Share = Beginning Book Value per Share + Retained Earnings per Share

Required Shareholder Earnings = Cost of Equity × Beginning Book Value per Share

Residual Income = Forecast EPS − Required Shareholder Earnings

Forecast EPS is calculated from Forecast ROE and Beginning Book Value per Share. Earnings that are not distributed to shareholders are retained and added to Book Value.

The Cost of Equity is applied to Beginning Book Value to determine the earnings required by shareholders. Residual Income is the amount by which Forecast EPS exceeds these required earnings.

Step 5 — Discount Residual Income

Present Value of Residual Incomeₜ = Residual Incomeₜ / (1 + Cost of Equity)^t

Present Value of Forecast Residual Income = Σ Present Value of Residual Incomeₜ

Each year's Forecast Residual Income is discounted back to present value using the Cost of Equity.

The discounted values from all forecast years are then added together to calculate the Present Value of Forecast Residual Income.

Step 6 — Calculate Terminal Value

Terminal Residual Income = Final-Year Residual Income × (1 + Terminal Growth)

Terminal Value = Terminal Residual Income / (Cost of Equity − Terminal Growth)

Present Value of Terminal Value = Terminal Value / (1 + Cost of Equity)ⁿ

Terminal Value represents the Residual Income expected after the explicit forecast period. The final Forecast Residual Income is grown at the Terminal Growth Rate and capitalized using the Cost of Equity.

The resulting Terminal Value is then discounted back to present value. If final-year Residual Income is not positive, the model assigns no Terminal Value.

Step 7 — Calculate Fair Value per Share

Fair Value per Share = Book Value per Share + Present Value of Forecast Residual Income + Present Value of Terminal Value

Fair Value per Share is calculated by adding current Book Value per Share, the Present Value of Forecast Residual Income and the Present Value of Terminal Value.

Book Value represents the equity already attributable to shareholders, while Residual Income captures the additional value created above the required shareholder return.