Residual Income and Stock Valuation Techniques
Does It Matter Which One You Use?
Chair of Banking, University of Alabama
Gary K. Taylor
Associate Professor, University of Alabama
ommon stockholders are the residual claimants of corporations. It follows that whatever cash flows remain after creditors have been paid are residual cash flows.1
In essence, all discounted cash flow (including dividends) stock valuation models could be considered residual income valuation models. However, advocates of economic value added (EVA), residual income (RI), and abnormal earnings growth (AEG) valuation methods have a specific definition in mind when using the term residual income.
For these three models, RI represents earnings above or below normal earnings. Normal earnings are those earnings generated by multiplying the required rate of return by the book value of equity.2
All three of these valuation techniques are used on Wall Street and taught in business schools. By way of illustration, consider Stowe et al., Analysis of Equity Investments: Valuation (2002). The chapter on residual income valuation states that EVA is a commercial implementation of the residual income “concept.” Similarly, Hirst and Hopkins, in Earnings: Measurement, Disclosure, and the Impact on Equity Valuation (2000), show that EVA is a specific version of the RI valuation model. However, EVA, RI, and AEG methods of valuation are quite different in their implementation. This chapter clarifies ...