The residual income valuation approach is a viable and increasingly popular method of valuation and can be implemented rather easily by even novice investors. When used alongside the other popular valuation approaches, residual income valuation can give you a clearer estimate of the true intrinsic value of a firm maybe. Residual income is the money that continues to flow after an initial investment of time and resources has been completed. Examples of residual income include artist royalties, rental income, interest income, and dividend payments.
The term residual income is used in other contexts:
- In personal finance, residual income can refer to an individual's discretionary income, or the total amount of money left over after paying all personal debts and obligations.
- In corporate finance, residual income is a measurement of corporate performance that reflects the total income generated after paying all relevant costs of capital.
Key Takeaways
- Personal residual income is not generated by hourly wages. Rather, it requires an initial investment of money or time or both with the primary objective of earning ongoing revenue.
- Residual income is often referred to as passive income.
- Sources of residual income include real estate investing, stocks, bonds, and royalties.
- Corporate residual income is leftover profit after paying all costs of capital.
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Residual Income
How Residual Income Works
Residual income broadly speaking is a measurement of tangential profits earned after subtracting all costs of capital related to generating that income. Other terms for residual income include economic value-added, economic profit, and abnormal earnings.
Although residual income is sometimes known as passive income, side hustles can be used to boost personal residual income.
Types of Residual Income
Stock Valuation
Residual income is also a valuation method for estimating the intrinsic value of a company's common stock. It accounts for the cost of capital, meaning the combination of debt and equity expended to finance the company's operations.
The residual income valuation model values a company as the sum of book value and the present value of expected future residual income. Residual income in this case is the profit remaining after the deduction of opportunity costs for all sources of capital.
Residual income is calculated as net income less a charge for the cost of capital. This is known as the equity charge and is calculated as the value of equity capital multiplied by the cost of equity or the required rate of return on equity.
The formula is:
Residual Income = Net Income - Equity Charge
Given the opportunity cost of equity, a company can have positive net income but negative residual income.
Corporate Finance
Managerial accounting defines residual income for a company as the amount of leftover operating profit after paying all costs of capital used to generate the revenues. It is also considered the company's net operating income or the amount of profit that exceeds its required rate of return.
Residual income in this case may be used to assess the performance of a capital investment, a team, a department, or a business unit.
The calculation of residual income is as follows: Residual income = operating income - (minimum required return x operating assets).
Personal Finance
In personal finance, residual income is synonymous with monthly disposable income. It is the total income that remains after paying all monthly debts.
Thus, residual income is often a key factor when a lender considers a loan application. An adequate amount of residual income indicates that the borrower can cover the monthly loan payment.
How to Generate Residual Income
Most sources of residual income require an upfront investment of money, sweat equity, or both. Some examples:
- Buy bonds. Once the bonds are purchased, the owner has a stream of cash available until the bonds reach their maturity.
- Buy a rental property. Renting out a second home or investment property is a sound way to add to your income without much effort after the initial investment. If you lack the seed money, consider renting out a spare bedroom.
- Invest in index funds: Your profits can grow over time even if you don't actively manage your investment.
- Peer-to-peer lending: The internet has opened the way to various types of residual income, including peer-to-peer lending. A number of platforms are available to facilitate personal unsecured loans between individuals at competitive rates of interest.
- Sell your stuff: In the broadest sense, residual income can be any side gig that adds to your income outside your regular job. eBay is good for cleaning out your closet and making money at the same time. Etsy is great for creative types who want to monetize a hobby.
Residual Income vs. Passive Income
The differences are subtle. Residual income may be passive income but passive income isn't necessarily residual.
In personal finance, passive income may be derived from stock dividends or from renting a room on Airbnb. There was an initial outlay of money to buy the stocks or the house, but a tangential benefit that costs little in additional time or effort has been derived from the initial investment. It is residual income as well as passive income.
- Passive income is earned with little or no effort required after the initial investment.
- Residual income, for an individual, means the free cash available for spending after all obligations are met.
Is Residual Income Taxable?
Yes, almost all residual income is taxable. Maybe the income from some tax-exempt municipal bonds is not taxed. Otherwise, whether you got the tax from stock dividends or renting your spare bedroom, it's taxable income.
Why Is Residual Income Important?
Residual income is often passive income. Passive income is, by definition, relatively effortless. Stock dividends and bond premiums are examples. To quote legendary investor Warren Buffet: "If you don't find a way to make money while you sleep, you will work until you die."
How Do I Calculate My Residual Income?
If you are applying for a loan, your residual income is the amount of money you have to spend after all of your monthly obligations have been paid. This is also called discretionary income.
If you are planning your long-term future, residual income takes on a different meaning. It is the amount of money you generate (or plan to generate in the future) from passive sources such as dividends and interest.
Which is an advantage of using residual income over return on investment quizlet?
The advantage of using residual income is that its use encourages managers to accept any project that earns a return that is above the minimum rate. This prevents the fallacy of using ROI that may reject a profitable project that reduces divisional ROI.
Why residual income is better than return on investment?
It is also better to use residual income in the undertaking of the new project because the use of ROI will reject any potential projects. The reason for this is that ROI yields lower returns on the initial investment whereas the residual income will maximize the income and not the return on investment.
Which is an advantage of using residual income RI over return on investment ROI?
RI promotes goal congruence better than ROI. The equation incorporates management's target rate of return. Management can use different target rates of return for divisions with different levels of risk.
What is an advantage of residual income?
Strengths of the residual income model include: The model gives less weight to terminal value. RI models use readily available accounting data. It can be used to value non-dividend paying companies. It can be used to value companies with no positive expected near-term free cash flows.
