Residual Income

Residual income has a variety of meanings. It can refer to the excess return a project generates over a company’s required rate of return (cf.) or cost of capital (depending on which metric a company uses to determine investability) after deducting all capital costs and other expenses required to create the project. Residual income is also an equity valuation model essentially based on the same concept as above i.e. it is a company’s net income minus the cost of equity used to generate it. If a company has positive net income but the return on equity is less than the cost of equity, the company is actually destroying shareholder value, which should be reflected in equity valuations. Residual income is measured by deducting an equity charge from net income. The equity charge is calculated by multiplying a company’s equity capital by the cost of equity (in percent)