Valuation is like figuring out how much something is worth. When it comes to stocks or companies, it’s about finding out the right price to pay for them.
Residual income valuation (RIV) is a method of equity valuation that is based on the idea that the value of a company is equal to the present value of its future residual incomes. Residual income is the income that a company generates after accounting for the cost of capital. In other words, it is the amount of income that is left over after the company has paid its investors the return that they require.
To understand RIV, it is important to understand the concept of cost of capital. The cost of capital is the rate of return that investors require on their investment in a company. It is the minimum return that a company must earn in order to satisfy its investors.
Imagine we’re assessing the value of xyz Ltd, an Indian tech company. We want to know if it’s a good investment. Here’s what we need:
- Expected Return: We estimate that xyz ltd should make a 10% return on the money invested in the company. So, if people like us have invested Rs 10,000, the expected profit should be 10% of Rs 10,000, which is Rs 1,000.
- Actual Profit: Now, we look at xyz’s actual profit for the year. Let’s say they made Rs 1,200 in profit.
Now, let’s calculate the Residual Income:
Formula: Residual Income = Actual Profit – Expected Profit
Residual Income = Rs 1,200 – Rs 1,000
Residual Income = Rs 200
Great! Xyz ltd has created Rs 200 more in profit than we expected. This Rs 200 is our Residual Income.
Now, to find out the company’s value using RIV, we add this Residual Income to the book value of equity. The book value of equity is simply the value of all the company’s assets minus its debts. Let’s assume xyz Ltd’s book value of equity is Rs 5,000.
Company’s Value = Book Value of Equity + Residual Income
Company’s Value = Rs 5,000 + Rs 200
Company’s Value = Rs 5,200
So, according to RIV, xyz limited is worth Rs 5,200, which is Rs 200 more than what we initially thought based on their profit.
In real-world scenarios, investors would use more complex financial data and calculations.
The RIV model is a relatively simple and easy-to-use valuation method. However, it has some limitations. One limitation is that it does not take into account the risk of the company’s future earnings. Another limitation is that it can be difficult to estimate the company’s cost of capital.
Also Read: Capital Expenditure (CapEx) vs Operational Expenditure (OpEx)
Despite these limitations, the RIV model can be a useful tool for valuing companies. It is particularly useful for valuing companies that are expected to generate high levels of residual income in the future.
Keep in mind that RIV is just one way to decide if a company is a good investment. It helps you look at the big picture and see if the company is making more money than it should, which is a good sign for investors.
