In Chapters 5 and 6, we covered dividend models and free cash flow to equity models.  In the simple dividend model, the value of a company to a shareholder is derived from cash dividends.  The free cash flow models value a company using “economic dividends,” whether paid in cash or not.

In this chapter, we will use the two major accounting statements the Balance Sheet and the Income Statement to study the Residual Income Valuation Model.  Although this model is analytically equivalent to the dividend model, the notable distinguishing feature of this model is that it formally accounts for the opportunity cost of capital.   One interpretation of the cost of equity capital (calculated, for example, from the Capital Asset Pricing Model or CAPM) is that it equals the rate of return required by investors from the resources under the control of the firm’s management.  Consequently, to create shareholder value, management must generate returns at least as great as this opportunity cost of capital.  From an accounting perspective, this is the essence of the concept of “residual income.”  Here, “residual” means in excess of the opportunity costs, and is measured relative to the book value of shareholders’ equity.  Finally we note that the valuation technique introduced in this chapter applies to any firm irrespective of whether or not it pays a dividend because the opportunity cost associated with not paying a dividend is correctly accounted for.

The specific learning objectives for this chapter are to understand:

·         The Relationship between the Residual Income Valuation (RIV) and Dividend Models

·         What is Comprehensive Income?

·         What is Residual Income?

·         How to apply the RIV to real world companies using Valuation Tutor

·         How to perform sensitivity analysis on the key drivers to test their reasonableness

·         What is the expected return from a stock using the RIV model