Residual Income Valuation Model

Residual income can be described as required return on common equity deducted from net income. If a company has its net profit margin lesser than equity capital cost, then it means the company does not have any economic profit regardless of its positive earnings.   

There are two types of RIV Model, single stage and multi-stage. The difference between a multi-stage dividend discount model and Residual income model is that the terminal value of dividend discount model is generally larger than that of terminal value of residual income. This is because, in the residual income model, the terminal value of residual income in the high growth period is considered as opposed to terminal value of the share price like in the dividend discount model. Also, it should be noted that the value is usually front loaded in RI model.

Residual Income Valuation Model

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Advantages of RIV model

This model offers more certainty in the valuation as opposed to other models. This is because it does not depend much on the terminal value as opposed to other models which have a significant consideration in terminal value. In RI model, the terminal value is not that significant. This is what results in a more certain value. This model also helps in understanding and getting the economic profit and not just in the positive earnings of a company. RI model is lot more flexible because it uses publicly available accounting data. Another major advantage for RI model is that it does not depend on dividend payment. RI model is more certain because it is not affected by unpredictable cash flows.

Limitations of RIV Model

A major disadvantage could be that the companies can subject this model to variety of accounting manipulations. RI model also requires great analysis and understanding of public financial reports. This is because the model might require adjustments to be in financial reports. In addition, it also requires a clean surplus relationship. The usage of RI model is done when no dividends are paid by the company. When negative values of free cash flow are expected or when the terminal value is highly uncertain. These are the conditions at which residual income model is used. This model is associated with cost of equity, dividend discount model and dividend growth model.