Page 28 - FINAL CFA II SLIDES JUNE 2019 DAY 8

LOS 32.d: Explain fundamental determinants of READING 32: RESIDUAL INCOME VALUATION
residual income.
MODULE 32.2: RESIDUAL INCOME COMPUTATION

Although residual income models don’t, but if we make the simplifying assumption of a constant dividend and earnings growth
rate, and that the stock is correctly priced (i.e., P = V ), value can be expressed in terms of book value:
0
0

The additional value generated by the firm’s ability to
produce returns in excess of the cost of equity and,
consequently, is the present value of a firm’s expected
economic profits (i.e., residual income).
Single-stage residual income valuation model: It
assumes constant ROE and constant earnings growth,
which implies that residual income will persist indefinitely.
Residual income is likely to approach zero over time,
however, as competitive forces drive industry profit
margins to normal levels. Thus, in practice, the single-
stage model is modified to handle declining RI by
forecasting continuing residual income.

We can use this relationship to identify the fundamental drivers of residual income:
• If ROE = required return on equity, the justified market value of a share of stock = book value.
• When ROE > required return on equity, the firm will have positive residual income and will be valued at more than book value.

LOS 32.e: Explain the relation between residual income valuation and the justified price-to-book ratio based
on forecasted fundamentals.

Residual income models are most closely related to the price-to-book value (P/B) ratio because the justified P/B is directly
linked to expected future residual income (see effects on formula above).