Residual Income Model
Equity value as book value plus the present value of excess returns over cost of equity.
Definition
The Residual Income Model (RIM) starts from book value and adds the present value of all future returns above the cost of equity. The intuition is powerful: a business is worth its accounting equity plus whatever economic value-added it can generate beyond what its shareholders require. It is more robust than DDM for non-dividend payers and less sensitive to terminal value than DCF. Used heavily in academic finance and the CFA curriculum.
Formula
Value = BV0 + sum_{t=1..inf} (RI_t / (1+Ke)^t)
RI_t = (ROE_t - Ke) * BV_{t-1}
where:
BV0 = current book value of equity
ROE = return on equity
Ke = cost of equityWorked example
A bank has book value $50/share, ROE 15%, cost of equity 10%. Residual income per share next year = (0.15 - 0.10) * 50 = $2.50. Capitalised at the spread sustaining for 10 years and fading thereafter, the model might add ~$22 in excess-return value, giving fair price ≈ $72.
How ARIA Analyst uses it
ARIA uses the Residual Income Model as a cross-check on DCF, especially for financial firms where free cash flow is notoriously hard to measure.
Related terms
Discounted Cash Flow (DCF)
Intrinsic value of an asset as the present value of its future cash flows.
Dividend Discount Model (DDM)
Equity value as the present value of all future dividends, often via the Gordon growth formula.
Return on Equity (ROE)
Net income divided by shareholders’ equity — profitability per dollar of equity capital.
Price-to-Book (P/B)
Market value of equity divided by accounting book value — classic asset-based metric.
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