What is Residual Income?
Residual Income is the money remaining after paying the necessary expenses and costs. In technical terms, it is the income that one generates in excess of the minimum rate of return or the opportunity cost of capital. There is a residual income formula that helps in ascertaining residual income.
Residual income is an important financial context, and one can apply it in personal finances and corporate operations. In corporate operations, residual income is helpful in two ways – equity valuation and corporate finance. In this article, however, we will focus primarily on the corporate uses of the residual income.
Residual Income and Corporate Finance
In this, the residual income is the excess of the company’s income over its opportunity cost of capital. One can calculate residual income in this case by subtracting the operating income from the desired income or the product of average operating assets and the minimum rate of return or opportunity cost of capital.
Residual Income Formula
Residual income formula, in this case, is – Operating Income Less Desired income.
Here operating income is the revenue less all necessary expenses and costs. And, the desired income is Minimum Required Rate of Return x Average Operating Assets. Average Operating Assets is the average of opening and closing balance of capital that a firm employs.
For example, Company A has an operating income of $50000, average operating assets of $200000 and the minimum rate of return of 10%. In this case, desired income will be $20000 (10%* $200000). Residual income will be $30000 ($50000-$20000).
How to Interpret Residual Income?
Residual Income is always in dollar value. A positive value suggests that the investment was able to generate more than the minimum return. So, the higher the residual income, the better it is.
Advantage and Disadvantage
It helps in evaluating the performance of the department and the managers. For instance, if the residual income is positive, then the performance targets are met.
A major disadvantage of residual income is that they may give inaccurate results when measuring investments of different sizes. The result would favor the investment with a bigger amount as the formula measure the dollar value.
For example, Company A has an operating income of $20000, and average capital assets of $40000. Company B has an operating income of $40000, and average capital assets of $90000. The cost of capital in both cases is 10%.
For Company A, the Residual Income will be $16000 ($20000 – 10%*$40000), while for Company B, it will be $31000 ($40000 – 10%*$90000).
On the basis of residual income both produce a positive result, i.e., they meet performance targets. However, it doesn’t tell which of the two is better. This we can tell by calculating ROI. For Company A, ROI is 50% ($20000/$40000), for Company B ROI is 44.44% ($40000/$90000). As per ROI, Company A is better.
Residual Income vs. ROI
Residual income is always in dollar terms, while ROI is in percentage. On the basis of residual income, all projects with a positive amount qualify for investment. However, under ROI, the projects with lower ROI (even if they have positive residual income) may fail to get approval.
Residual Income for Equity Valuation
Residual income is also a useful input for equity valuation. In fact, Residual Income Valuation is one of the common methods for valuing equity. Under this, residual income serves as economic earnings stream, which we then discount to get the intrinsic value of a company’s common stock.
Such a valuation method values the company as the total of book value and the present value of the future residual income streams. Residual incomes measure the economic profit or the profit after accounting for the true cost of capital. True cost of capital here means both the cost of debt and cost of equity.
Net income only considers the cost of debt and does not take into account the cost of equity. Items like dividends and other equity distributions do not come in use while calculating net income. This is why net income does not represent economic profit.
It is possible that a company may have a positive net income, but a negative residual income or economic loss. So, for the purpose of equity valuation, residual income is the net income adjusted for the cost of equity. The cost of equity is the rate of return that investors ask for as compensation for the opportunity cost and corresponding level of risk
Residual Income Formula
Residual income formula, in this case, is Net Income – Equity Charge. Here Equity Charge is Equity Capital x Cost of Equity.
After calculating the residual income, we can calculate the intrinsic value of a stock, which is the current book value of equity plus the present value of future residual incomes discounted at a relevant cost of equity.
Such a valuation method is suitable for mature companies that do not distribute dividend or are unpredictable when it comes to the dividend payment. Also, companies that don’t have positive cash flows can use this valuation method.
Though the residual income model is not as popular as DCF (discounted cash flow), analysts still heavily use it. However, just like DCF this method, one can easily manipulate the residual income method by wrong assumptions.
Personal Residual Income
In personal finance, residual income (or discretionary income) is the leftover money after paying for debts each month.
Residual Income Formula
In this case, the residual income formula is – Monthly Salary Less Monthly Debt Payments.
For example, John’s monthly salary is $10,000, while his monthly debt includes $2000 car debt, and a $4000 mortgage. The residual income in this case will be $4000 ($10,000 – ($2000 + $4000)). John can use $4000 to buy a new asset, or put into savings, or both.
Banks also use this residual income concept when approving a loan request from an individual. The residual incomes concept allows banks to know if the applicant makes enough money to pay his existing debt and the additional loan payment as well. So, higher the residual income, more are the chances of you getting a loan.
Many also define residual income as the income from a passive source. This means an income without a direct input of effort or time or without the need to manage. We can say only an investment creates additional revenue with no effort from the investor. For example, once you invest money in a dividend stock, it will continue to provide you with additional income. Other examples are royalties, rent and more.