Residual Income
Valuing a company as its book value plus the present value of the profit it earns above its cost of capital. It puts the return-against-cost comparison at the centre.
MadStockAlerts Research · Updated August 28, 2026
What to take away
- Value equals book value plus discounted residual income.
- Residual income is earnings less a charge for the equity employed.
- A company earning exactly its cost of capital is worth its book value.
- Less of the value sits in a terminal assumption than in a DCF.
- It depends on accounting book value, which the balance sheet article's caveats apply to.
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Profit After Charging for Capital
Residual income subtracts a charge for the equity used, which is why a profitable company can still be destroying value.
This lesson is part of a Stock Alerts + Tools plan.
The construction
value = book value + present value of (net income - cost of equity x book value)
- the bracketed term is residual income: profit above a charge for the capital employed
- a company earning exactly its cost of equity generates none, and is worth its book value
That last consequence is the model's central intuition. Value above book value comes entirely from earning more than the cost of the capital, which is the same idea the return on capital article expresses as economic profit.
Why the terminal value matters less
In a discounted cash flow, most of the value typically sits in a terminal assumption. In a residual income model, a large part of the value is book value, which is observed rather than forecast.
Scroll the chart sideways to see all of it.
- Discounted cash flow
- Residual income
That is the model's main practical argument. It does not make the future more knowable; it reduces how much of the answer depends on it.
What it inherits
- It depends on book value, which understates companies whose assets are internally generated intangibles.
- It assumes clean surplus accounting, which is violated by items bypassing the income statement.
- It still requires a cost of equity, which is estimated rather than observed.
- Forecasting residual income requires forecasting both profit and the book value it is charged against.
The first item is the same criticism that has weakened price-to-book and the value factor. In a market where much of the asset base is not on the balance sheet, a model anchored to book value inherits that limitation.
Where it is most useful
| Situation | Why the model suits it |
|---|---|
| Financial companies | Book value is measured close to fair value and is meaningful |
| Companies with negative free cash flow | A DCF struggles; earnings-based residual income does not |
| Comparing return against cost directly | The comparison is the model's central term |
| Cross-checking a DCF | A second construction with a different sensitivity profile |
The relationship to price-to-book
The model produces a direct explanation of what a price-to-book ratio means, which the ratio itself never supplies.
price to book ≈ 1 + present value of future residual income / book value
- a company earning exactly its cost of equity trades at book value
- the premium above book is the capitalised value of returns above the cost of capital
That makes the ratio interpretable rather than merely observed. A price-to-book of three is a statement that the market expects returns above the cost of equity, sustained long enough to be worth twice the book value again.
It also produces a check. If a company's return on equity is close to its cost of equity, a price-to-book far above one implies an expectation that the return will rise, and that expectation can be examined directly.