# Residual Income Valuation Method: Intrinsic Value Calculation

Residual income valuation method is another way to estimate intrinsic value of stocks.

How effective is this method of estimating intrinsic value?

I would say, it is a rather stringent method of calculation.

It value stocks by adding a ‘factor‘ to its book value (net worth).

This additional factor is what is derived from “residual income method”.

Intrinsic Value = Book value + Factor.

Before going into the details of residual income valuation method, here are few of my observation on this method.

##### Observation 1:

Intrinsic value estimated by this method is often too low.

It is hard to find a good stock trading at such low price levels.

I am yet to find a good stock which has its market price below the intrinsic value as calculated by residual income method.

##### Observation 2:

The “residual income factor” contributes only a small portion to the total intrinsic value. Just for exemplification:

Intrinsic Value (100%) = Book Value (93%) + Factor (7%)

More examples of Residual Income Factor contributing to the total intrinsic value are as follows:

• Ajanta Pharma – 48.9%.
• Gujarat Pipavav –  7.2%.
• Lupin – 6.5%.
• MRF – 4.9%.
• Syngene International – 25.7%.
• Vardhman textile – 29.6%.

When I realised this limitation of Residual Income Method of stock valuation, I was rather sad.

Book value is something that is published widely and we can get it free from any genuine website.

The whole effort that goes into estimating the “Residual Income Factor” part was as little as 7.2%, 6.5%, 4.9%? Seriously? It was a rather sad realisation.

##### Observation 3:

But this was also true that there were some stocks, which displayed a rather higher “factor” percentages (Ajanta, Syngene, Vardhman etc).

Does this signify anything?

Initially I though that high “factor” percentage will mean stock is undervalued. But I was wrong.

During this exercise, I observed a very interesting pattern.

A combination of low P/E ratio (generally below 20), and high Residual Income factor is necessarily making the stock undervalued.

I understand that this is a generalisation of things, but it works fine for me.

So, I decided to include the residual income method in my stock analysis worksheet.

## Residual Income & other methods…

Residual income method is used by many value investors to value stocks.

It is a reasonably good tool for estimating intrinsic value of stocks.

Other methods that are used for calculating intrinsic value are:

Financial ratios can also be used to judge if a stock is correctly priced or not. But it is not very accurate.

It is used mostly by untrained investors.

But what is the alternative available for untrained investors?

People who do not know how to calculate intrinsic value of stocks, what they can do?

[I know this, and this is the reason why I have developed an stock analysis worksheet for my readers. Though it is not a stock advice tool, but I have personally find it to be reasonably helpful.]

Residual income valuation method is a effective way of intrinsic value calculation of stocks.

Why I like residual income method of stock valuation?

This is one method which is easy to use even by lay investors like me and you.

I often use residual income method with DCF.

Though DCF is more complicated method of valuation but results of residual income method is by far more conservative than DCF.

What does it mean?

If Intrinsic value is a range, DCF helps me to see the upper side of it. Residual income valuation method give the lower side.

## Residual Income Formula

Lets see how to estimate intrinsic value of stocks using residual income model.

Residual Income = Net Profit (PAT) – Cost of Equity

In residual income calculation cost of Equity is used to value stocks.

But cost of equity is not directly indicated in financial statements.

It is a important information that potential investors must learn to calculate.

Cost of equity is the cost incurred by companies to keep shareholders glued to their stocks.

By investing in stocks of a company, shareholders takes risk.

These shareholders expect to be compensated for the risk they take.

Good companies are very sensitive to this requirement of shareholders.

They genuinely believe in the concept of providing risk compensation to its shareholders in long term.

If this is not done, them why people will buy their stocks?

They will be better off by buying a bank deposit or bonds where risk of loss is much lower.

Of course, risk compensation to shareholders cannot be practiced until the company itself is doing good business.

So, to take care of the shareholders the company must first take care of themselves.

It means, to adequately compensate the shareholders, the company is not asked to do anything out of the box.

When company grows, shareholders also benefits.

So in a Residual Income Formula, cost of equity is a very important part.

## How much should be the Cost of Equity?

More than the prevailing risk free rate.

Investors invest in stocks. They do it while they have the option of investing in fixed deposit, why?

For higher returns.

Hence for a company, the cost of equity cannot be too low. This will make them less preferable.

Cost of Equity = Equity Capital (Net Worth) x Expected Returns

By maintaining a higher cost of equity, companies keep investors interested in their stocks.

High volume stocks are more likely to get popular and gain market value (market cap).

The rise in market capitalisation not only helps the investors but it also helps the underlying company.

Raising capital in equity market becomes easier.

## The concept of Residual Income

A company with higher residual income should be the preferred choice of investors.

When two companies has the same net profit (PAT), choice of investors shall be one with higher residual income.

One of the cost of equity is dividend payment to shareholders.

Dividend is paid on both preference shares and equity shares.

We know that in the cost of equity we have a component called “Expected Returns”.

Investors can earn returns in two ways:

• (a) through dividends, and
• (b) through capital appreciation.

Expected Returns = Dividend + Market Price Appreciation of Stock

A profit making company can ensure both dividend payment and price appreciation to its shareholders.

Companies profit is indicated in P&L accounts as Net Profit (PAT).

Dividend earning of shareholders happens immediately as soon as the company (varies for company to company) generates reasonable PAT.

But market price appreciation takes time.

The majority portion of shareholders returns come from price appreciation.

And this is where the shareholders are expected to wait to see the returns really flowing-in.

This understanding is ok, but where is residual income?

Residual Income = Net Profit (PAT) – [Cost of Equity]

= Net Profit (PAT) – [Net Worth x Expected Returns]

= Net Profit (PAT) – [Cost of Dividend Payment + Cost of Ensuring Capital Appreciation]

##### What does this formula signify?

Company pays dividends and also ensure capital appreciation.

But doing like this has a huge cost on the company.

A company which still have some money in its pocked after ensuring the cost of equity is good for investing. Why?

Because these are those companies which are making money for its shareholders and also for themselves.

After attending to the shareholders interest, if some residual income remains, it is a huge indicator that the company is likely to repeat (or even better) the performance next year.

So investors must also always look for companies having substantial residual income.

Companies showing only positive PAT is not enough.

## Quality of EPS : Growth & Quantum

For investors, looking only at net profit (PAT) is not sufficient. It is important to see if EPS is growing as well.

Investors should be more interested in EPS growth. Why?

EPS growth will ensure future market price appreciation of stock.

But it take a lot of effort on part of the company to ensure consistent EPS growth.

If EPS is growing fast enough, company can pay dividends and also ensure future price appreciation.

But some company may fool investors by paying high dividends. How?

When companies pay dividend, that money goes straight into the pocket of the shareholders.

It adds no value to the companies operations.

But to ensure future EPS growth, companies operations must also grow.

Companies which spend majority of its net income in dividends do this to please investors.

But it may happen that the remaining fund is not sufficient to fund future EPS grow.

Such companies either depend on debt or they sell more equity.

In both the case existing shareholder value is compromised.

To identify such companies, use of residual income method is very effective.

So coming back to our point, looking only at PAT is not enough.

A company which is reporting \$10 million PAT may prove more profitable for investors than a \$100 million PAT company. How?

By doing residual income calculation one can know which company is contributing more to the balance sheet reserves.

Fast growing balance sheet reserves ensures EPS growth.

Higher future EPS growth rate in turn will ensure higher returns for investors.

## Residual Income Calculation Example

Two hypothetical companies X & Y

Company X:

• Market Price = Rs 847.0/ share,
• Stock Beta 1.06,
• Equity Capital = Rs 13,273.37 Crore,
• Reported Net income = Rs 20,286 Cr.

Company Y:

• Market Price = Rs 338.7/ share,
• Stocks Beta 0.93,
• Equity Capital = Rs 2,427.95 Crore,
• Reported net income = Rs 10,220 Cr.

#### #Step-1. Calculate Expected Returns

Expected Return = Rf + b (Rm – Rf)
Rf = Risk Free Rate (7%)
Rm = Expected Market Return for period of say 5 years (12.5%)
b = stock beta

Company X
Expected Return (Re) =Rf + b (Rm – Rf) = 7 + 1.06 x (12.5 – 7) = 12.83%

Company Y
Expected Return (Re) = Rf + b (Rm – Rf) = 7 + 0.93 x (12.5 – 7) = 12.11%

Example showing how my stock analysis worksheet calculates expected returns:

#### #Step-2. Calculate Cost of Equity

Company X
Cost of equity = Equity Capital x Expected return = Rs 130,273.37 Cr. X 12.83% = Rs 16,714 Cr.

Company Y
Cost of equity = Equity Capital x Expected return = Rs 2,427.95 Cr. X 12.11% = Rs 294 Cr.

Example showing how my stock analysis worksheet calculates expected returns:

#### #Step-3. Calculate Residual Income

Company X
Residual Income = Reported Net Profit – Cost of Equity = Rs (20,286 – 16,714) = Rs 3,571

Residual income = Rs 3,571 Cr.

Company Y
Residual Income = Reported Net Profit – Cost of Equity = Rs (10,220 – 294) = Rs 9,926
Residual income = Rs 9,926 Cr.

Example showing how my stock analysis worksheet calculates expected returns:

[P.Note: Though Company X has reported double the net income (PAT) as compared to company Y, but still its residual income is less than company Y.]

#### #Step-4. Calculate Intrinsic Value

Intrinsic Value = Book Value + PV of Residual Incomes (5Y)*

* Present Value of all residual incomes forecasted for next 5 years.

Assuming following details for an example company ABC

• Residual Income = Rs.30, 31, 32, 33 & 34/share for next 5 years.
• Expected Returns = 12.8% per annum.
• Book Value = 446/ share.
• Current Market Price: Rs.847/share.

PV of Residual Incomes = 30/ (1+0.128)^1 + 31/ (1+0.128)^2 + 32/ (1+0.128)^3 + 33/ (1+0.128)^4 + 34/ (1+0.128)^5 = Rs.112

Intrinsic Value = Book Value + PV of Residual Incomes.

Intrinsic Value = 446 + 112 = Rs.558

By using the residual income valuation method we have estimated the intrinsic value of ABC as Rs.558

As the current Market Price of ABC (Rs.847) is more than its intrinsic value (Rs.558), hence ABC is overvalued.

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