Residual Income Valuation

Discounted cash flow and dividend discount models both value a company purely from its future distributions, ignoring the book value already sitting on the balance sheet. Residual income valuation starts from book value instead: it says a company's equity is worth its current book value, plus the present value of every future year's "residual income" — the accounting profit earned above and beyond what shareholders' capital could have earned at their required rate of return, i.e. net income minus a capital charge of (required return × beginning book value).

If a company earns exactly its cost of equity every year, residual income is zero every year, and the model collapses to saying the stock is worth its book value — a useful sanity check. Only earnings genuinely above the cost of capital add value beyond book, and earnings below it subtract value, which is what makes the framework attractive for valuing companies with volatile or currently negative free cash flow: book value provides a stable anchor that a pure discounted-cash-flow model lacks in the near term.

A company with $50 book value per share, $6 expected net income per share, and a 10% cost of equity has a capital charge of $10\% \times 50 = 5$, so residual income is $6 - 5 = 1$ per share this year — only that $1 of "excess" profit, discounted over all future years, adds to the $50 of book value already counted.