Residual Income Valuation Model

Name: Residual Income Valuation Model (English version)
SKU: 122070

Wang, Charles C.Y.; Shin, Albert

Product #:122070

Supplier:Harvard Business School

Discipline:Accounting

Details:Note (PDF) • 15 pages • 2022-01-13

Subjects:

Accounting Financial performance measurement Value creation Finance and investing Financial analysis Strategy Finance and investing Accounting

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This note explains the residual income valuation model (RIM), how it relates to "traditional" valuation models, the intuition behind its use, and empirical research related to its value relevance. RIM is theoretically equivalent to the dividend discount model and the discounted free cash flow model. However, it expresses future cash flows to equity in terms of accounting measures of capital (e.g., book value of equity) and performance (e.g., return on equity). Implementing the RIM requires forecasting the amount of expected future "economic profits," which depends on how business strategy plays out in the context of industry competitive dynamics, effective management of financial capital, and governance.

Learning Objectives

This note is intended to facilitate and deepen students' understanding of the residual income valuation model and the patterns of mean reversion in accounting profitability. The note allows for analysis and discussions about different valuation models, the role of accounting numbers in valuation, and forecasting accounting profitability.