Residual income

Residual income equals reported net income minus a capital charge for the equity employed in the business, computed as cost of equity times beginning book equity. The construct converts accounting earnings into economic earnings: a business that earns 8% on book equity while its cost of equity is 10% has positive accounting earnings but negative residual income — it is consuming shareholder capital, not creating it. The residual-income valuation model expresses equity value as the current book value plus the present value of future residual income, discounted at cost of equity. For financial firms — banks, insurers, asset managers — where book equity is meaningful and free cash flow is awkward to construct, residual income is often the most natural valuation lens. It also has the elegant property that, unlike DCF, the bulk of the value is anchored to a balance-sheet number rather than an extrapolated terminal value, which makes it less sensitive to terminal-growth assumptions. Where residual income falls short is in asset-light businesses, where book equity bears little resemblance to the productive asset base and the model collapses into a near-pure earnings projection.