Performance Measurement by Residual Income Method
In ACCA Advanced Performance Management (APM), residual income is one of performance measure in strategic performance measurement. You are required to understand the application of this measure.
By word residual means whatever is left of, so residual income would imply to be whatever is left for after deducting all expenses. Theoretically, the residual income is business performance or evaluation measure in terms of equity return.
Shareholders invest money in a business and expect return against it, as they bear all the risk for their money. Many other measures can be used in performance or total equity evaluations such as dividend discount model, ROCE, ROI, or EVA, etc. Residual income stresses on economic value added more than measuring net profits.
Residual Income Definition and Formula
Residual income can be defined in many ways; essentially it is the net income minus the charge for net assets employed in the business. The net assets of the business are what shareholders’ are left with. The term can also be dubbed as an equity charge.
In net profit calculations, the cost of capital or debt cost includes the interest charged. The Residual income (RI) model incorporates a similar charge for equity employed in the business.
Residual Income can be calculated as:
Residual Income (RI) = Net profits – Equity Charge
Equity Charge = Total Equity × Cost of Equity Capital
The equity charge is deducted to evaluate the true value of profits generated by the business for the equity holders i.e. shareholders. It is considered the compensation for shareholders as an opportunity cost that shareholders bear for investing money in the business. The notion behind evaluating company performance with a Residual Income is that net profits may not be good enough compensation for risky investments that Shareholders take on.
In that way, a business may be generating positive cash flows and surplus net profits, but with Residual income may still not be positive. The effects of residual income expectations and the difference between net profits and residual income can be explained with the help of a simple example.
Suppose Aramex co. has the following abstract from their Income Statement:
For residual income calculations:
Capital (Equity plus long-term debt) = $ 70,000
Cost of equity = 13%
So Equity Charge = $ 70,000 × 13% = $ 9,100
The equity charge of $9,100 represents the minimum return required by the providers of finance on the $70,000 capital they provided. Since the actual profit of the division exceeds this, the division has recorded residual income of $900.
Brief History of Residual Income Method
The first use of the residual income method dates back to the 1800s when Alfred Marshal introduced the concept in his book “Some Fundamental Notion”. In recent history, the researchers Liu et al. (2002), Feltham and Ohlson (1995), Ohlson (1995), and Penman (1997, 2001) have argued for the residual income method by comparing it closely with the discounted cash flow method.
The modernized and a similar approach to the residual income model is the economic value added (EVA) model. That builds closely on the RI basis with a slight variation of using net profit after tax and using total cost charge. It uses total cost and WACC to calculate the total cost charge instead of the equity charge used in the residual income method.
Residual Income Interpretation as a Performance Measure
If we can embed the equity charge into the income statement and calculate the residual income for one accounting period, it can be used to evaluate the stocks for any number of years too. This approach is very similar to the dividend discount model, or NPV calculations with DCFs when evaluating the future stock or project performances.
For business valuation in terms of Residual Income, the current book value of the stocks and future income (RI) is calculated in terms of present value. The fair value of the business can be calculated as:
The RI model takes into account the current book value of the stocks and adds the present value of future residual income with the stock.
Suppose Beta Co. expects the EPS for the company for the next three years as $2.00, $ 2.50, and $ 4.00. The current Share price is given at $ 47. The Book value of the share is $ 6.00 with an expected rate of equity at 7%. Expected dividends for the next three years are $ 1.00, $ 1.25, and $ 5.30.
Using the residual income formula, we can calculate the residual income for the next three years and the value of the stocks in the present value term.
And RI = Net profits – Equity Charge, and
Equity Charge = Total Equity × Cost of Equity Capital
So the Value of Stock can be calculated as:
Residual Income Uses in Practice
The residual income method can be used in practice for performance evaluation similar to the DDM or DCF methods. As it incorporates the equity charge at the expected rate of return of shareholders, it can be used to evaluate the value of the business. A project proposal with cash flows expected in the future can also be discounted in present value terms, provided the cost of equity for the project is known or calculable.
In corporate finance, the top management may also consider the residual income method to evaluate project specific or divisional performances based on equity rate of return charged Residual income. As this approach subtracts the equity charge from the net profits after tax, it may offer a reasonable insight into the actual performance of the project or a division within a business.
Advantages of the Residual Income Method
The residual income method can be used in both performance appraisals of a project, division, and business valuations. It considers the future cash flows in the present value term, which is the most liked approach in investment appraisals.
Its benefits closely resemble those arising from the dividend discount model or discounted cash flow models in present value terms. Some benefits of the Residual Income method in performance appraisals and business valuations include:
It focuses on the economic profits of the business rather than operating profits
It appraises the project net income in terms of present value, the residual income then equals the net worth of the shareholders
Residual income utilizes readily available data from the business financial statements
The Residual Income method includes the book value of stocks in addition to the future stock price appreciation
It offers an adequate performance measure in terms of shareholders’ expectations, often profit generating businesses may not be generating enough economic profits for the shareholders
Disadvantages of the Residual Income Method
As with any theoretical performance appraisal method, the residual income method also offers some limitations:
The use of book value for stock appraisals or asset valuation in project appraisal may offer invalid forecasts, as the book value of asset may not be accurate as market or intrinsic values
The Residual Income model also uses the cost of equity and cost of capital from The Income statement, both of which are assumption based measure
Residual income discards the long-term gains arising with cash flows in the later stages of the project
The residual income calculations begin with the book value of stocks or the net profits from the Income statement, these accounting entries can be manipulated by managers to show positive results
Residual income in modern times is closely used with economic value added models. It offers deeper insights into business performance in terms of economic profitability. It is a more shareholder centric approach in terms of stock valuations. It relies on the assumption that debt costs are incorporated with interest charges, and equity costs should also be compensated the same way. Apart from book value use of assets and an estimation of future cash flows that may not be accurate, the residual income method offers valuable insights in performance appraisals.
Residual income is also a popular topic in ACCA APM exam. For example, one part in a question in December 2019 APM exam asked candidates to calculate a change in residual income. This type of question has been examined in previous levels and just make sure you understand how to calculate and you can get the marks.
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