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Subject 4. Fundamental Determinants of Residual Income PDF Download
In the last section we developed the following expression:

P0/B0 = (ROE - g) / (r - g) = 1 + (ROE - r) / (r - g)

As P0 = V0, this expression is equivalent to:

V0 = B0 + B0 x (ROE - r) / (r - g)

This expression is called a single-stage residual income model. It splits intrinsic value of a stock into two components: the book value per share B0, and the present value of the expected level stream of residual income, (ROE - r) x B0.

The second term B0 x (ROE - r) / (r - g) = extra value from firm's ability to produce returns > cost of equity = PV of firm's expected economic profits.

  • If ROE = r, RI = 0 and MV = BV.
  • If ROE > r, RI > 0 and MV > BV.

The key point to remember from this discussion is that residual income depends on the present value of the company's future profitability (ROE) and the current book value of equity. These two factors are the fundamental determinants of residual income.

Example: Base Case

All equity firm. Equity capital = $1,000. NI = $250 into perpetuity. r = 15%. long-term growth rate = 5%.

ROE = 250/1000 = 0.25. V B0 + ((ROE - r)/(r - g)) x B0 = 1,000 + ((0.25 - 0.15)/(0.15 - 0.05)) x 1,000 = $2,000.

Example: New Investment w/ ROI > r

New investment = $1,000 addition capital. ROI = 20%, which is less than the current ROE, but greater than r which remains at 15%.

Equity capital: 1,000 + 1,000 = $2,000.
NI = 250 + 200 = $450 into perpetuity.
ROE = 450/2,000 = 22.5%.
V = 2,000 + ((0.225 - 0.15)/(0.15 - 0.05)) x 2,000 = $3,500.

Although firm value increased by $1,500 only $500 of value has been created because $1,000 of the growth was additional invested capital.

Example: New Investment w/ ROI < r

New Investment = $500 additional capital. ROI = 10% which is positive, but less than r.

Equity capital: $1,000 + $500 = $1,500.
NI = $250 + $50 = $300 into perpetuity.
ROE = 300/1,500 = 20%.
V = 1,500 + ((0.20 - 0.15)/(0.15 - 0.05)) x 1,500 = $2,250.

Although firm value increased by $225, the initial investment was $500. Therefore, $250 of value was destroyed because ROI < r.

Residual income valuation and justified P/B ratio relationship

A justified price multiple for the stock is the estimated fair value of that multiple. RIMs can be used to establish market multiples such as P/E or P/B. For example, justified P/B is directly linked to expected future RI.

P0/B0 = 1 + Present value of expected future RIs/B0

When the present value of expected future residual income is positive (negative), the justified P/B based on fundamentals is greater (less) than 1.

Learning Outcome Statements

explain fundamental determinants of residual income;

explain the relation between residual income valuation and the justified price-to-book ratio based on forecasted fundamentals;

calculate and interpret the intrinsic value of a common stock using single-stage (constant-growth) and multistage residual income models;

CFA® 2023 Level II Curriculum, Volume 4, Module 26

User Contributed Comments 2

User Comment
Allen88 (ROE - r + r -g)/(r-g)= (ROE -r)/(r-g) + 1.
davidt876 an implicit assumption is that the retention ratio cannot = 1 forever
otherwise g = ROE*1 = ROE and then the starting equation doesn't make sense:

P0/B0 = (ROE-g)/(r-g) = 0/(r-g) = 0
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I just wanted to share the good news that I passed CFA Level I!!! Thank you for your help - I think the online question bank helped cut the clutter and made a positive difference.
Edward Liu

Edward Liu

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