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Residual income calculation of stocks is essential. It helps investors to estimate its intrinsic value. It is not easy to calculate intrinsic value of companies. Few commonly methods used for calculating intrinsic value are (1) comparative method, (2) discounted cash flow model, (3) dividend discount model & (4) residual income model. Comparative method is an easy way of estimating intrinsic value of stocks. It is used mostly by untrained investors. Comparative method is not so reliable. Discounted cash flow model and Dividend discount model is popular and widely used by investors. Residual income model is another effective method of intrinsic value calculation of stocks. Experts use residual income calculation to estimate intrinsic value of stocks. In this article we will see basic know-how of residual income calculation.

Residual Income Calculation and Cost of Capital

In residual income calculation cost of capital is used to value stocks. Cost of capital is means cost of debt + cost of equity. The interest paid by companies on debts are termed as cost of debt. Interest paid by companies on its debt is indicated in their income statement. But cost of equity is not directly indicated in financial statements. Cost of equity is important for shareholders. 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. In stock investing, risk compensation must be done for investors who stay invested for long term. If not them why a people will buy stocks? They will be better off by buying a bank deposit or bonds where risk of loss is negligible. By maintaining a higher cost of equity, companies keep investors interested in their stocks. Higher cost of capital means ensures more trading of stocks. More trading means higher volume. Popular stocks has higher trading volume.

Residual Income = Net Profit (PAT) Cost of Equity

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 biggest cost of equity is dividend payment to shareholders. Dividend is paid on both preference shares and equity shares. Cost of equity component in our formula is related to total dividend paid + expected return .

Residual Income Calculation and Intrinsic Value of Stocks

For investors looking only at net profit (PAT) is not sufficient. A company may be reporting high PAT, but if majority of it is spend to fund cost of equity then it is not considered good. Net income shall be effectively used to fund companies growth. Investors are more interested in EPS growth. When companies pay dividend, that money is simply shareholders income. Dividends cannot be used to fund companies EPS growth. 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. A company which is reporting $10 million as net income may prove more profitable for investors than a PAT $100 million company . How? This is where residual income calculation is helpful. By doing residual income calculation one can know which company is contributing more to balance sheet reserves. It is balance sheet reserves which ensures EPS growth. Growth in EPS in turn will ensure high expected returns .