Equity Markets, Valuation, and Analysis

CHAPTER 13Residual Income Valuation

Shailendra Pandit

Associate Professor of Accounting, University of Illinois at Chicago

Somnath Das

Professor of Accounting, University of Illinois at Chicago

INTRODUCTION

The modern corporation operates on the principle of shareholder value maximization. To create wealth for its owners, a firm must earn more on its invested capital than the cost of that capital. Firm stakeholders evaluate a firm's financial performance using various measures, such as revenues, earnings, cash flows, and return on investment. Residual income (RI) is a commonly used metric that captures the net surplus generated by the firm. RI and accounting-based net income (NI) share some similarities in that both RI and NI subtract operating expenses and taxes from revenues to arrive at profits. However, RI differs from NI in a crucial aspect: whereas NI defines profits net of interest expense, RI measures profits net of the cost of both debt and equity capital. Thus, RI accounts for the opportunity cost of the total capital employed in the business (Biddle, Bowen, and Wallace 1997, 1999).

Current accounting rules do not permit reflecting the cost of equity in reported income. Therefore, proponents of RI advocate adjusting reported income by subtracting an additional charge for the cost of equity. In combining income and opportunity cost, RI contrasts the factual course of action with the counterfactual course of action (Magni 2009). Since RI measures a firm's profit above ...