What is a Residual Income Model?
Also called the abnormal earnings valuation model, the residual income model is a method for predicting stock prices.
How Does a Residual Income Model Work?
In this theory, every stock is worth the company's book value per share if investors expect the company to earn a 'normal' rate of return in the future. The decisions of management -- and the earnings results -- are what make a stock worth more or less than that book value benchmark.
So, for instance, if the book value per share of Company XYZ is $5, then any unexpected financial results -- that is, any residual income -- will make the stock price deviate from that $5 mark. Those unexpected results are attributable to the management -- either it is underdelivering or overdelivering profits to the shareholders -- and indicate that the company is not going to earn a 'normal' rate of return in the future. If Company XYZ begins reporting earnings per share for the quarter that are above Wall Street expectations, then management essentially gets the credit for any increase in the stock above that book value per share threshold. Likewise, if Company XYZ reports lower-than-expected earnings per share, then management also will get the blame for any decrease in the stock below book value per share.
Why Does a Residual Income Model Matter?
The primary philosophy behind the residual income model is that the portion of a stock's price that is above or below book value is attributable to the expertise of the company's management. Accordingly, it becomes a handy tool for calculating what the 'real' value of a stock is. It is important to note, however, that analysts should pay special attention to incorporating changes in book value per share caused by share buybacks and other unusual events that may distort the analysis.