Residual Income and Excess Return Models

The Core Insight (Why It Matters)

Accounting profit ignores something fundamental: capital has a cost. A company that earns $10 million but required $100 million in equity earning a 10% return has not created value—it merely met expectations.

Residual income measures what remains after subtracting the cost of equity capital:

RI = Net Income - (Equity Capital x Cost of Equity)

Or equivalently:

RI = (ROE - r) x Book Value

Where:

• ROE = Return on equity
• r = Required return on equity (cost of equity)

The point is: Only when ROE exceeds your required return does a company create value. Everything else is just meeting the minimum threshold investors demand for taking equity risk.

Residual Income vs. EVA (Know the Difference)

Both measure excess returns, but they answer different questions.

Residual Income (RI)

RI = Net Income - (Equity x Cost of Equity)

RI measures value creation for equity holders only. You use cost of equity as the hurdle rate and equity capital as the base.

Economic Value Added (EVA)

EVA = NOPAT - (Invested Capital x WACC)

Or equivalently:

EVA = (ROIC - WACC) x Invested Capital

EVA measures value creation for all capital providers—debt and equity combined. You use WACC as the hurdle rate and total invested capital as the base.

The durable lesson: RI is for equity investors. EVA is for evaluating total business performance. Using the wrong cost of capital produces nonsense.

Worked Example: EVA Calculation

Consider a manufacturing company:

Step 1: Calculate capital charge

Capital Charge = $50M x 8% = $4 million

Step 2: Calculate EVA

EVA = $8M - $4M = $4 million

Interpretation: This company created $4 million in value above what investors required. Positive EVA signals genuine economic profit—the business earns more than its cost of capital.

Now consider the alternative:

EVA = $3M - $4M = -$1 million

This company destroyed $1 million in value. Despite reporting positive accounting profit, it failed to cover its cost of capital.

Why this matters: Accounting profit can mislead. A company with $3 million in net income looks profitable. EVA reveals it is actually destroying shareholder value.

The Residual Income Valuation Model

You can value a company by adding the present value of all future residual income to current book value:

V0 = B0 + Sum of [RIt / (1+r)^t]

Where:

• B0 = Current book value of equity
• RIt = Residual income in period t
• r = Cost of equity

Worked Example: RI Valuation

A company with:

• Current book value (B0): $25 per share
• Expected EPS: $4.00
• Cost of equity: 12%
• Projected ROE: 16% (stable)

Step 1: Calculate annual residual income

Equity charge = $25 x 12% = $3.00

RI = $4.00 - $3.00 = $1.00 per share

Step 2: Calculate present value of perpetual RI

If RI stays at $1.00 forever with no growth:

PV of RI = $1.00 / 0.12 = $8.33

Step 3: Calculate intrinsic value

V0 = $25 + $8.33 = $33.33 per share

The durable lesson: The residual income approach anchors on book value (known) and adds premium for excess returns (projected). This often produces more stable valuations than DCF for companies with negative or volatile free cash flows.

When to Use RI Models vs. DCF

Use Residual Income When:

1. The firm does not pay dividends or has unpredictable dividend patterns (RI works from accounting data)
2. Free cash flow is negative but positive cash flow is expected later (tech companies reinvesting heavily)
3. Book value is meaningful and relatively stable (financial services, manufacturing)
4. You distrust long terminal value horizons (RI often has lower terminal value weight)

Stick with DCF When:

1. Cash flow is the relevant measure (real estate, infrastructure)
2. Book value is distorted by accounting policies or intangible assets
3. The company has a clear path to stable cash generation

The point is: RI models shine when dividends are absent and book value is reliable. DCF wins when cash flow is the economic reality. Neither is universally superior.

EVA Value Drivers (What Actually Creates Value)

EVA was invented by Stern Value Management in 1983. Understanding what drives EVA helps identify genuine value creators:

Driver 1: Asset Management

• Turn working capital faster to release cash
• Increase capacity utilization and economies of scale
• Cut underperforming assets earning less than cost of capital

Driver 2: Operating Margin Improvement

• Reduce operating costs without sacrificing quality
• Improve pricing power through differentiation
• Increase revenue without proportional cost increases

Driver 3: Capital Efficiency

• Reduce capital tied up in low-return assets
• Optimize inventory levels
• Improve receivables collection

The chain of logic:

Higher margins -> Higher NOPAT -> Higher EVA (if capital stays constant)

Lower invested capital -> Lower capital charge -> Higher EVA (if NOPAT stays constant)

Higher ROIC relative to WACC -> More value creation -> Higher stock price

Accounting Adjustments for EVA

GAAP accounting does not measure economic profit. Common adjustments include:

1. Capitalize R&D: Add R&D spending back to invested capital; amortize over useful life
2. Capitalize operating leases: Add present value of lease obligations to capital
3. Add back depreciation: Charge economic depreciation instead
4. Adjust provisions: Add allowances and reserves back to invested capital

Why this matters: For technology firms with heavy R&D, expensing distorts both earnings and capital. EVA adjustments reveal true economic returns. However, this makes EVA more suited to asset-heavy companies where these adjustments matter less.

Common Errors in RI/EVA Analysis

Error 1: Using the Wrong Cost of Capital

RI requires cost of equity. EVA requires WACC. Mixing these produces meaningless numbers.

Error 2: Not Adjusting Book Value

Book value on the balance sheet reflects accounting conventions, not economic reality. R&D expensing, lease treatment, and depreciation policies all distort the capital base.

Error 3: Applying EVA to Asset-Light Businesses

EVA works best for companies with significant tangible assets. For software or services firms where value comes from intangibles, the invested capital denominator becomes arbitrary.

The durable lesson: Match the model to the business. EVA tells you something meaningful about a manufacturer. It tells you less about a software company whose value is people and code.

Cross-Checking Your RI Valuation

Your residual income value should reconcile with:

• DCF value (if you use consistent assumptions, they should converge)
• Market price (large gaps indicate either opportunity or assumption error)
• Trading multiples (your implied P/B should match sector norms)

If RI valuation says $50 and DCF says $35 for the same company with the same assumptions, you have an error somewhere. Find it.

Next Step

Calculate EVA for a company you own using data from its annual report. Find NOPAT (operating income x (1 - tax rate)), invested capital (total assets minus non-interest-bearing liabilities), and estimate WACC. Determine whether the company creates or destroys value. If EVA is negative, calculate what ROIC improvement would turn it positive. That target becomes your threshold for holding the position.