residual income income

JonnyKay

Does anyone have a good way of remembering all the formulas in the residual income reading? they are much less intuitive to me....

genuinecfa

eh, there is intuition there. if it's worth your time, try to figure out what they are doing.

Like start with residual income is addition amount earned over required, that's N.I. - r_e*BVo. Or in terms of rates, it's (ROE - r)*BVo.

Whenever you have a stream of cash flows, you take the stream/(r-g) to get the PV. Here the stream = Residual Income (either of the two formulas in the prior sentence)

In this case total value is your current BV + anticipated excess returns: = BVo + R.I./(r-g).

You just have to get the idea down that it's excess earning in a period, and then determine if this amount becomes stable/constant, so that you can use the R.I/(r-g) formula. If not, you have to look at it period by period.

Also, it's always using net incomes, and equity values for discounting and returns. So debt is not considered anywhere.

ap0258

Edit--- When I started writing didn't see SeesFA answer. Good answer there too.


Well, I guess the way I try to remember is start with what residual income is trying to accomplish.

Its how much more we made than what we needed.
Also I try to remember Book Value. Residual Income used Book Value to offset the downside of Gordon Growth Dividend Model which is highly sensitive to your terminal value.

So the key to all the formulas is Book Value + PV of Residual Income. They can ask the question a variety of ways and you can use a variety of models you already know only substituting in residual income.

NI - (required return*Equity)
or
divide both number by equity and you get

ROE (As a proxy for what me made) - r (what we need to make)


All residual income applications seem to key in on Book Value + PV(residual income) - so remember that.

Single stage --- Lets remember our Gordon Growth

D1/(r-g)


So excess earnings - thats BV(ROE-R) (which is the same as its net income less equity charge)
substitute for D1
Get
BV(ROE-R)/(r-g)

Then when you look at answer you realize well that just gets me my excess value (because RI only includes income above hurdle "r"). Its so small you will know you need to add something and thats why I remember Residual Income = Book Value (which also keeps me from using Market Value) So add BV which gives you a starting place.

So then its Value = BV+(ROE-R)*BV/r-g

Basically if you can do you other formulas, you can hopefully figure out the residual income version.



Edited 1 time(s). Last edit at Thursday, May 26, 2011 at 03:14PM by stingreye.

onelife1

wow that helps fellas!!

OmarAdnan

wat abt those economic profit,economic income stuff. That is what is not intuitive to me