Residual Income Model

Residual Income Model - Valuation Residual Income Model...

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Unformatted text preview: Valuation: Residual Income Model Residual Income Model • This approach values “residual” or “abnormal” income available for equity holders • Concept: – If a firm can earn only a “normal” return on book value, then it’s worth only book value – Worth more/less if return on BV is above/below “normal” What is “residual” income? • Normal earnings are the “expected” earnings given a company’s cost of equity capital. Residual income (or abnormal earnings) is the difference between the actual earnings and the “expected” earnings. – residual income = (ROCE - rE) x book value – Or, alternatively: • expected earnings = book value x rE • residual income = net income – expected earnings Residual Income Valuation – The Residual Income Model values equity directly in one step – Value of Equity at time t = current book value plus sum of discounted future residual income ∑ ∞ + = + + 1 t τ τ t equity) of cost (1 τ] year for income [residual E t time at Equity of Value Book Implementing RIM Valuation...
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Residual Income Model - Valuation Residual Income Model...

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