The Residual Income Model is a popular option for valuing businesses. The model assumes that the value of a company equals the present value of all future residual incomes, discounted at the cost of equity. This model uses the principle of residual income, which is an estimation of the free cash flow available to the owners of a business after investors’ return requirements have been satisfied (usually via dividends). This can be a more accurate way to value a company than other methods, such as asset- or earnings-based methods. In this article, we will explain the residual income valuation model and how to use it to value a business.
We will also look at the Residual Income Valuation Model template on Magnimetrics.com and how you can easily set it up and use it to value any company.
What is the Residual Income Model?
The residual income model is based on the concept of residual income, which is the free cash flow available to the owners of a business after all expenses have been paid. The model uses this principle to value a company by discounting the future residual incomes at the company’s cost of equity. In other words, the model values a company based on its ability to generate cash flow after all expenses have been paid.
The residual income valuation model is a popular option for valuing businesses because it is relatively simple and easy to use.
The model takes into account the company’s future ability to generate cash flow, rather than just its past performance
Benefits and Limitations of the Residual Income Model
Some of the benefits of using the Residual Income Valuation model are:
- It is relatively simple to understand and easy to calculate.
- It is more accurate than other methods, such as the asset-based or earnings-based methods.
- It considers a company’s future residual incomes (as an estimate for cash flows), which is essential in making investment decisions.
- We can use it to value companies with different capital structures or in various stages of their life cycle.
There are also some limitations to the residual income valuation model.
- It does not consider the time value of money.
- It assumes the company reinvests all residual incomes at the cost of equity.
- It does not consider other forms of capital such as debt or preferred stock.
- Estimating a company’s future performance can be challenging, and the model relies heavily on forward-looking estimates.
Despite these drawbacks, the residual income model is still helpful in valuing companies.
When to Use the Residual Income Model
The model is useful when valuing companies that don’t pay dividends or with historically negative free cash flows.
For dividend-paying enterprises, we typically prefer the Dividend Discount Model (DDM). In contrast, we would usually rely on a Discounted Cash Flows (DCF) model for companies not paying dividends but still generating free cash flows.
How to Value a Company with the Residual Income Model
To use the residual income valuation model to value a business, we will need to estimate the company’s future residual incomes and discount them at the cost of equity.
We can calculate Residual Income by subtracting a charge for its cost of capital (Equity Charge) from the Net Income. The Equity Charge represents the expected returns through dividends, and we multiply the equity capital’s value by the equity cost to arrive at it.
- r is the discount rate which is usually the cost of equity or the required rate of return for the equity investors
Now that we have the Equity charge, we subtract it from the Net Income to arrive at the Residual Income:
We can then calculate the company’s present value as the sum of all projected residual incomes in perpetuity, discounted at the cost of equity rate.
The following formula outlines the calculation:
- BV is the current book value of equity
- t is the current period
- r is the discount rate (cost of equity)
Most commonly, we assume that the company achieves maturity at some point, reflected in what we call ‘constant growth.’ Then, applying a concept from the Perpetuity Growth Model, we calculate the corresponding Terminal Value from the year the constant growth is assumed to start.
- m is the first period after the projected periods
- g is the expected stable growth rate
Using the above, we can augment the formula for RI valuation to:
The model is a valuable tool for valuing companies expected to grow in the future, focusing on the company’s ability to generate free cash flows. It is a popular valuation method for startups, as they usually don’t have historical data.
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Using the Residual Income Valuation Model Template on Magnimetrics
If you are looking to implement the method to estimate the current value of a business, we got you covered.
We have prepared a sample residual income valuation model template on the Magnimetrics platform that you can use and extend as needed.
Prep Step: Get Your Free Magnimetrics Account
To use the Standard Costing Variance Analysis template (and others we are constantly adding), you need a Magnimetrics account. You can register for free (no credit card required).
So why wait? Get started today and see how Magnimetrics can help you translate your financial data into meaningful insights.
Step 1: Import the Residual Income Valuation Model Template to your Projects
You can find the Residual Income Valuation Model template in the Start With a Template section on your Dashboard.
You can also create a New Project and select the template from the drop-down menu.
Either way, please select the option to Copy Over Sample Data so that all necessary data points are available in your project.
Step 2: Adjust the inputs on the Assumptions tab
After the app imports the template, it will take you to the Project Dashboard.
First we can go to the Assumptions tab where you can change the discount rate and growth rate as needed:
- DISCOUNT_RATE: the Cost of Equity (expected return for investors)
- GROWTH_RATE: the expected stable growth rate after the company matures (applied for all periods after the projected ones, in perpetuity)
Step 3: Import your Projections
(You can skip this step if you want to stick to the dummy data and see how the template works)
Head to the Data Imports tab. There are two import templates here:
- Equity Schedule Projections: Here you can import your projected equity raises in the following years. Alternatively, you can also directly edit the values here. The Share Equity Closing Balance is the line item we need, as we use it to calculate the Equity Charge.
- Income Statement Projections: I have imported all line items from an Income Statement forecast, which I am using to calculate the Net Income figure for each period. If you import a different set of lines, you will need to adjust the Net Income calculation on the Formulas tab.
Step 4: Run the Residual Income Valuation Model report
After importing or adjusting all the necessary data, head to the Reports tab and Launch the Residual Income Valuation Model report.
The app will show the executed report which outlines the process of applying the Residual Income Valuation Model with all relevant calculation steps, giving you the final estimate of the intrinsic value of the business.
If you are feeling adventurous and want to know how everything works, click Edit Report to look under the hood, get more familiar with how we add calculation logic and display tables, or adjust the report to your liking. You can also go to the Formulas tab to see how the template calculates each intermediate step.
Step 5: Download the Results in PDF
You can also export the launched report as PDF with the button on the top right.
The residual income valuation model is an increasingly popular option for valuing businesses. It is a great model for the toolkit of any analyst. As with any valuation method, there are advantages and disadvantages to using the residual income valuation model. It would be best if you used it alongside other valuation methods to get the most accurate estimate of the true intrinsic value of the business. Do you have experience using the residual income valuation model? What do you think? Let us know in the comments below.
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