We can use the following equation to forecast the residual income:
RIt = Et − (r × Bt − 1) = (ROE − r) × Bt − 1
where:
RIt = residual income per share in year t
Et = expected EPS for year t
r = required return on equity
Bt − 1 = book value per share in year t − 1
ROE = expected return on new investments (expected return on equity)
With forecasted residual income values, we can create an estimate of the intrinsic value of a stock. The residual income valuation model is composed of two components, the current book value of equity and the present value of expected future residual income:
where:
B0 = current book value of equity
RIt = Et − (r × Bt −1) = (ROE − r) × Bt −1
r = required return on equity
ROE = expected return on new investments (expected return on equity)
In other words, a stocks intrinsic value is the sum of its book value and the present value of all its expected future residual income. Note that estimating this present value is very difficult, and usually the CFA will give us a timeline of a certain number of years before a company goes defunct.
A characteristic of the Residual Income model is that is less sensitive to terminal value estimates, which reduces forecast error. The current book value is a large component of the estimate, and it does not have to be guessed. Another way to state this is that the Residual Income model recognizes value earlier than terminal value-based models.
Finally, we can also calculate RI as:
Net Income – Equity Charge
where
Equity charge = BOY Shareholder equity x required return on equity