- CFA Exams
- CFA Exam: Level II 2021
- Study Session 11. Equity Valuation (3)
- Reading 30. Residual Income Valuation
- Subject 3. The residual income valuation model

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**CFA Practice Question**

A company has a book value of $5 per share. It is expected to earn $0.60 per share in perpetuity, pays out all of its earnings as dividends, and has a required rate of return on equity of 10%. Calculate the value of the stock using the dividend discount model and the residual income model.

Correct Answer: Dividend Discount Model:

V

It pays out all its earnings: BV

RI

Present value of stream of residual income: RI

V

V

_{0}= D/r = 0.6 / 10% = $6.Residual Income Model:

It pays out all its earnings: BV

_{0}= BV_{1}= BV_{2}= ... = BV_{t}= $5.RI

_{t}= E - r x B_{t-1}= $0.6 - 0.1 x $5 = $0.1.Present value of stream of residual income: RI

_{t}/ r = $0.1 / 0.1 = $1.V

_{0}= BV_{0}+ Present value of expected future per-share residual income = $5 + $1 = $6.###
**User Contributed Comments**
2

User |
Comment |
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tengo |
use the single stage model with g=0% and roe=12% and bv =5 |

Rotigga |
Or alternatively: ROE = NI / Equity BV = 0.6 / $5 = 0.12 V0 = B0 + (ROE - r) * B0 / r = 5 + (0.12 - 0.1)*5 / 0.1 = $6 |