Module 32.2 LOS 32.d: Fundamental determinants of Residual Income

Using a single-stage residual income model, we can highlight the fundamental drivers of residual income.

We can equate B₀ to the book value, the assets of a firm net its liabilities. The portion in brackets represents the present value of the expected future residual income. It could also be described as the present value of a firm’s expected economic profits, the ability of the firm to produce returns in excess of its cost of equity.

From this we can also see that if return on equity (ROE) is equal to the required return on equity, the justified market value of a share of stock is equal to its book value. When ROE is higher than the required return on equity, the firm will have positive residual income and will be valued at more than book value.

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