The Residual Income Method of Business Valuation

Abstract

application in the business valuation community, despite its many advantages. The RIM is a method of valuation within the income approach. The primary features distinguishing the RIM from the more familiar discounted cash flow (DCF) method are (1) that it is based on accrual accounting net income rather than net cash flows, and (2) that it relies upon accounting book value as the anchor of value. It is often claimed, under the banner of “cash is king,” that cash flow is a better measure of value than accounting net income due to management’s ability to manipulate the latter. However, the RIM in fact yields exactly the same value, as does the DCF method when applied with the same valuation assumptions. This article illustrates the basic features of the RIM, and compares the results of applying it to those yielded by the DCF method. II. The Residual Income Method The RIM employs concepts similar to economic value added (EVA) analysis, 3 in that it measures value added in terms of earnings in excess of the required rate of return on capital employed. Starting with the value of its existing capital, a firm adds value only to the extent that its returns exceed its cost of capital. Thus, under the RIM, the value of equity (Ve) is calculated using the following general formula: