Reading 21

Residual Income Valuation

5 modules 26 min
0/5

Exam Focus

This topic review introduces the fourth type of valuation model found in the CFA curriculum: Residual income models. You should understand the differences between these models and the dividend discount, free cash flow, and market multiple models. The successful application of residual income models depends on making the appropriate adjustments to the financial statements, so you also should be able to use the techniques you learned in the Financial Statement Analysis material in applying these models.

The concept of continuing residual income is also related to the material on industry analysis in FSA. With all these links to other concepts in the Level II curriculum, this material is highly testable.

Modules

  1. Module 21.1Residual Income DefinedCalculate and interpret residual income, economic value added, and market value added. · Describe the uses of residual income models.4 min · 2 LOS
  2. Module 21.2Residual Income ComputationCalculate the intrinsic value of a common stock using the residual income model and compare value recognition in residual income and other present value models. · Explain fundamental determinants of residual income. · Explain the relation between residual income valuation and the justified price to book ratio based on forecasted fundamentals.5 min · 3 LOS
  3. Module 21.3Constant Growth Model for RICalculate and interpret the intrinsic value of a common stock using single stage (constant growth) and multistage residual income models. · Calculate the implied growth rate in residual income, given the market price to book ratio and an estimate of the required rate of return on equity.2 min · 2 LOS
  4. Module 21.4Continuing Residual IncomeExplain continuing residual income and justify an estimate of continuing residual income at the forecast horizon, given company and industry prospects.7 min · 1 LOS
  5. Module 21.5Strengths/WeaknessesCompare residual income models to dividend discount and free cash flow models. · Explain strengths and weaknesses of residual income models and justify the selection of a residual income model to value a company’s common stock. · Describe accounting issues in applying residual income models.8 min · 3 LOS
Practice quiz14 questions on this reading