Residual Income Valuation Model

The residual income valuation model (RIM) is an alternative model to the the discounted cash flow method or valuation based on multiples in determining a company’s value. It decomposes the company’s value into two imaginative parts:

1. The first part comprises the real assets of the company. It is assumed that these assets are leased to the company at a certain rate of return. We will later see that this rate of return is the expected return on equity by the company’s shareholders.

2. The second part is the present value of the future “Residual Incomes”. Like the cashflows of a DCF valuation these future residual incomes are discounted back to the present. Residual income refers to the income part which is achieved above the expected return on the real assets (the previously mentioned first part). But it is best explained by the following expample.

Residual Income Valuation Example

To understand this concept let’s assume the following risidual income valuation example: Mario the plumber wants to start a business and is able to win his Grandma to invest $100 as a venture capitalist to start his plumbing business. With this money Mario buys the tools necessary for the job. Since Granny’s money is at stake she requires him to pay a yearly dividend of 10% on her invested capital. After working extremely hard, the business ends up holding $30 in cash at the end of the year. The balance sheet looks like this:

Balance sheet in one year from now:

Assets:	Equity:
$30 cash	$100 Grandma's capital
$100 tools	$10 dividend payable to Grandma
	$20 residual income

$130	$130

Let's now look at the two parts defined earlier in order to value the business according to the residual income valuation model. We will add up the two parts:

1. Real assets refer to all assets needed for the operational part of the business. Since the cash position is partially payed out as Grandma’s dividend ($10) and partially carried on the books as residual income ($20) not employed in the operational part of the business, the real assets part amounts only to $100 in tools.

2. The residual income part refers to all future earnings which are above the expected return of the leased assets. For year one, the required income on the real assets amounts to $100 (real assets) x 10% (lease rate) = $10 (the amount of money Granny requires as dividend). The residual income therefore is $30 - $10 = $20. Assuming constant residual incomes until eternity we discount all future residual incomes to the present through a perpetuity calculation. We divide the residual income amount of $20 by our fully equity financed firm’s discount rate of 10%. This results in $20 (residual income per year)/10%(discount rate) = $200.

The value of Mario the plumber’s business (technically Mario the plumber’s Grandma’s business) put together is now $100 (real assets) + $200 (future discounted residual incomes) = $300.
Note that we receive the same result by calculating a perpetuity of $30 in incomes and discount rate of 10%, which again turns out to be $30/10%=$300.

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