We built this residual income calculator to help you calculate a company's residual income. Residual income is a very useful metric used to value a company. Residual income is widely use in company valuation as it measures economic profit instead of accounting profit.

This article will help you understand what is the residual income meaning and how to calculate residual income. We will also show you some examples to help you understand how to apply the residual income model.

What is residual income? Residual income definition

We can understand the residual income as economic profit. The residual income definition is income after deducting all the equity charges from the accounting net income, where the equity charges reflects the opportunity cost of capital of the equity stockholders.

The accounting net income is often stated after deducing a company's interest expenses, which means it takes care of the cost of debt. However, it does not reflect the cost of the equity capital. Hence, from the equity holder's perspective, one can argue that accounting net income often overstates the returns to the stockholders.

We can solve this problem by calculating the residual income, which considers the cost of equity by deducting the equity charge from the accounting net income. In short, the residual income meaning is the return after all capital costs, both debt and equity, are deducted.

How to calculate residual income using the residual income formula?

To understand the residual income model, we must first understand its formula.

Let's take Company Alpha, which reports the following information, as an example:

  • Company: Company Alpha;
  • Net income: $80,520,000;
  • Return on equity: 12.3%; and
  • Equity capital: $800,000,000.

There are 3 steps that you need to take to calculate the residual income.

  1. Determine the company's net income

The company's net income can be found on the income statement of most companies. It is the bottom line of a company, so net income will always be the last line of the income statement. It is recommended that you get this information from the company's annual report.

In our example, the net income of Company Alpha is $80,520,000.

  1. Calculate the company's equity charge

The next thing we need to do is to calculate the company's equity charge. The equity charge reflects the cost of opportunity for all the equity holders. It is defined as the product of equity capital and the cost of equity.

Equity capital, or total stockholders' equity, is the amount of equity being injected into the company by its shareholders. The equity capital is displayed in the company's balance sheet. For Company Alpha, the equity capital is $800,000,000.

The cost of equity can be calculated using various methods. The most common method being the Capital Asset Pricing Model (CAPM). In our example, the cost of equity for Company Alpha is 12.3%.

Now, the equity charge can be calculated using the following formula:

equity charge = equity capital * cost of equity

The equity charge for Company Alpha can be calculated as:

$800,000,000 * 12.3% = 98,400,000.

  1. Calculate the residual income using the residual income formula

Lastly, we need to calculate the residual income for Company Alpha. The residual income formula is displayed as follow:

residual income = net income - equity charge

Hence, the residual income for Company Alpha is -$17,880,000.

The importance of residual income

Now, let's understand the residual income meaning further.

  • Residual income helps us to understand economic profit

Calculating the residual income allows us to understand the economic profit that a company is generating. The net income, or net profit, reported on the income statement only takes into account the cost of debt, which is reflected by the interest expenses. However, this is not very useful for stockholders as the cost of equity is not reflected in net income. Calculating residual income is one of the best ways to solve this issue as it reflects the actual income going to the stockholders.

For instance, Company Alpha seems profitable as it has a positive net income. However, after deducting the equity charge from the accounting net income, Company Alpha is actually economically unprofitable, given its negative residual income.

  • Residual income is also useful in performing a company valuation

According to the residual income model, the share price of the company is equivalent to its book value per share plus the present value of its residual income per share (PV) . This can be shown as:

share price = book value per share + PV

Hence, calculating residual income can help us value a company as well.

FAQ

What is the difference between residual income and net income?

Net income is equivalent to accounting income whereas residual income equals to the economic income. Residual income is the income after deducting both costs for debt and equity investors.

Can residual income be negative?

Yes, residual income can be negative. A negative residual income means that the company is not economically profitable, even though it may be profitable on an accounting basis.

What is a good residual income?

In general, a higher residual income signifies that the company is more economically profitable. However, to determine if a company's residual income is 'good', we need to compare it against its peers.

What is residual income most commonly used for?

Residual income is useful in determining if a company is economically profitable, hence providing value to its shareholders. It can also be used to perform company valuation using the residual income valuation model.

Wei Bin Loo
Equity Charge
Equity capital
$
Cost of equity
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Equity charge
$
Residual income
Net income
$
Residual income
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