Explain what residual income models are used for

Residual income models serve several purposes. They value equity, especially where a company pays no dividend or has negative free cash flow. They help judge management, since positive residual income means the company is earning more than its cost of equity. Economic value added, a form of residual income, is used in executive pay schemes and to assess divisions. Analysts also use the idea to read market expectations: a price-to-book ratio above one implies the market expects positive residual income. Impairment testing and equity research screens draw on the same logic. The trap is assuming that positive accounting profit means value is being created, when after the charge for equity capital residual income may still be negative.