Residual Income Valuation

Why is Residual Income Valuation Important?
Residual Income Valuation (RIV) is a crucial concept for CFA Level 2 candidates as it provides an alternative approach to valuing equity securities. It focuses on a company's ability to generate excess returns above the required rate of return, making it a valuable tool for investment analysis and decision-making.

What is Residual Income Valuation?
RIV is a valuation method that determines the intrinsic value of a company's stock by considering the present value of its expected future residual income. Residual income is the earnings generated by a company in excess of its cost of equity capital. The RIV model assumes that a company's value is equal to its book value of equity plus the present value of its expected future residual income.

How Does Residual Income Valuation Work?
To calculate the intrinsic value using RIV, follow these steps:
1. Determine the company's book value of equity.
2. Estimate the company's future earnings and required rate of return on equity (cost of equity).
3. Calculate the expected residual income for each future period by subtracting the product of the book value of equity and the required rate of return from the estimated earnings.
4. Discount the expected future residual income to the present value using the required rate of return.
5. Add the present value of expected future residual income to the current book value of equity to obtain the intrinsic value of the company's stock.

Exam Tips: Answering Questions on Residual Income Valuation
1. Understand the key inputs: Be familiar with the components required for RIV, such as book value of equity, estimated future earnings, and the cost of equity.
2. Know the formula: Memorize the RIV formula to calculate the intrinsic value efficiently during the exam.
3. Interpret the results: A stock is considered undervalued if the intrinsic value is higher than the current market price and overvalued if the intrinsic value is lower.
4. Compare with other valuation methods: Be prepared to contrast RIV with other valuation approaches, such as the dividend discount model or the price-to-earnings ratio.
5. Practice, practice, practice: Work through various RIV questions to familiarize yourself with the concept and its application in different scenarios.