Residual income

Net income minus a charge for the cost of equity on opening book value: what is earned after shareholders receive their required return. Positive only when ROE exceeds the cost of equity.

Where you will meet it

Residual income appears in 15 learning outcomes on the CFA syllabus. A few of them:

• Contrast what FCFF, FCFE, dividend and residual income models each need as inputs
  CFA Level I · Equity Investments

  “The residual income model starts from current book value and adds the present value of earnings above the equity charge, RI = (ROE - r) x beginning book value.”

• Contrast relative with absolute valuation models and give examples of each kind
  CFA Level II · Equities

  “Absolute valuation models estimate intrinsic value from the asset's own characteristics, usually by discounting expected dividends, free cash flow or residual income.”

• Explain the general criteria for picking a suitable way to value a particular company
  CFA Level II · Equities

  “It should fit the business: dividend models for steady payers whose dividends track earnings, free cash flow models for firms whose cash generation differs from what they pay out, residual income where free cash flow is negative for years, and asset-based approaches where assets are mostly financial or liquidation is likely.”

• Contrast dividends, residual income and free cash flow as DCF inputs and say in which investment settings each one fits
  CFA Level II · Equities

  “Residual income, profit above a charge for equity capital, suits companies with negative free cash flow for the foreseeable future or no dividends, provided the accounting is of good quality.”

See also

Required return

Practise it

• Today's practice question One question, with every wrong option explained.
• Free Level I diagnostic test Twelve questions that show which topics to start with.
• Free finance calculators Check your arithmetic on the exam's core formulas.

All terms beginning with R · Glossary