Calculate residual income as net income minus the equity capital charge to determine whether a company creates or destroys economic value.
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Equity Valuation
Residual income measures profit above and beyond the minimum return required by shareholders. Positive residual income signals economic value creation; negative signals value destruction even when accounting profits are positive.
Accounting profit can be positive while the company still fails to earn its cost of equity. Residual income deducts an equity charge — the opportunity cost of shareholders' capital — from net income to show whether the company truly creates value.
The concept underpins the residual income valuation model (RIM), an alternative to DCF that values a company as book equity plus the present value of future residual income streams.
Subtract the equity charge from net income.
Residual Income = Net Income − (Equity Capital × Cost of Equity)
Equity Capital = book value of shareholders' equity. Cost of Equity = required return on equity (e.g. from CAPM).
A company earns 500,000 in net income with 3,000,000 in equity capital and a 10% cost of equity. Equity charge = 3,000,000 × 10% = 300,000. Residual income = 500,000 − 300,000 = 200,000. The company creates 200,000 of economic value.
Relies on accounting book values, which may not reflect economic reality. Cost of equity estimation (via CAPM or build-up method) introduces model risk. Single-period measure that may not capture long-term trends.
Frequently asked questions
Net income only deducts explicit costs (including interest on debt). Residual income also deducts the implicit cost of equity capital, showing whether shareholders earn more than their required return.
The equity charge = Book Equity × Cost of Equity. It represents the minimum profit needed to compensate shareholders for the risk of their invested capital.
Yes. If net income is positive but below the equity charge, residual income is negative — the company earns accounting profit but destroys economic value.
The residual income model (RIM) values equity as book value + PV of future residual income. It is particularly useful for financial institutions where free cash flow models are difficult to apply.
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