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CFA Level II · CFA Level II Exam

Residual Income Valuation for CFA Level II

Residual income is net income minus a charge for the cost of equity capital. The residual income model values a stock as current book value plus the present value of expected future residual income. To solve questions, find book value, ROE and cost of equity in the vignette, forecast residual income, then discount.

What this chapter covers

This chapter teaches you to value equity using accounting numbers instead of dividends or free cash flow. Residual income (RI) is the profit left after you charge the company for the cost of the equity it uses. If a firm earns more than its cost of equity, RI is positive and the stock is worth more than book value. If it earns less, the stock is worth less.

The chapter has a clear sequence. You learn the equity charge and the RI formula, then build the multi-period model, then handle how long RI lasts through persistence factors and terminal value. After that come the links to sustainable growth and ROE, the accounting issues that distort book value and earnings, and finally when the model is the right choice.

It connects to several other areas of the paper. It sits with the other equity valuation chapters (discounted dividends, free cash flow, market multiples), so you must know when each model fits. It also leans on Financial Statement Analysis, because clean surplus violations, fair value changes and non-recurring items come from the financial statements. Cost of equity ideas link to Portfolio Construction and Corporate Finance.

Residual income appears inside Equities item sets, and the vignette will give you book value, ROE, cost of equity and growth or persistence assumptions. The calculations are short once you know the structure, so this is a chapter where a well-prepared candidate converts points reliably. It also rewards judgment questions, such as which model suits a firm with negative free cash flow or no dividends. Since you must answer from the vignette, practise pulling the right inputs rather than recalling definitions, and remember that Equities carries a 10-15% topic weight.

Residual Income Valuation: topics in the order to study them

  1. 1Residual Income Concepts and Equity ChargeStart here because everything else builds on the idea of charging for equity capital and on the formula RI = net income − (cost of equity × beginning book value).
  2. 2Residual Income Valuation ModelNext, put the concept to work: value = book value today + present value of expected future RI, in single-stage and multistage form.
  3. 3Residual Income Persistence and Terminal ValueTerminal value is where most of the value and most of the exam judgment sits, so study it right after the basic model.
  4. 4Sustainable Growth, ROE and Implied MetricsThese give you the growth and ROE inputs for the model and let you back out the market-implied growth or ROE from a price.
  5. 5Accounting Issues and Clean Surplus RelationOnce you can compute values, learn how accounting choices and clean surplus violations distort the inputs and how to adjust for them.
  6. 6Strengths, Weaknesses and Use of Residual Income ModelsFinish with model selection, which is easier once you have used the model and seen its weak points.

How to prepare Residual Income Valuation

Treat this as a short, formula-driven chapter. Aim for fluency in a few calculations and clear judgment on when to use them.

  1. Write the core formulas from memory: equity charge, RI, and value = B0 + Σ RI_t ÷ (1 + r)^t. Check your recall until it is automatic.
  2. Do one-period and multi-period RI calculations by hand. Always charge cost of equity on beginning book value, and roll book value forward using retained earnings.
  3. Practise terminal value with a persistence factor. Learn how a higher or lower persistence changes the value, and what each extreme case means.
  4. Solve for implied ROE or implied growth from a given price, so you can reverse the model quickly.
  5. Read vignettes and underline the inputs: book value, ROE, cost of equity, payout, growth. Then decide which are beginning and which are ending values.
  6. Build a short comparison list of strengths and weaknesses of RI against dividend discount and free cash flow models, and practise matching it to company types.
  7. Finish with timed item sets that mix this chapter with other equity valuation methods, and review each wrong answer for the input you misread.

Common mistakes in Residual Income Valuation

  • Charging the equity charge on ending book value instead of beginning book value.

    Fix: Label each balance by date as you read. Use the book value at the start of the period for each year's charge.

  • Forgetting to add current book value to the present value of RI.

    Fix: Write the formula first every time: value = B0 + PV of RI. Check that your answer has a book value component.

  • Misreading the persistence factor in terminal value.

    Fix: Remember that a persistence factor near 1 means RI lasts, and near 0 means it disappears quickly. Test with the extreme cases.

  • Rolling book value forward with the wrong payout.

    Fix: Use ending book value = beginning book value + net income − dividends, and compute dividends from the payout ratio given.

  • Ignoring clean surplus violations and accounting quality.

    Fix: Scan each vignette for items taken directly to equity, goodwill or reserves, and note how they change book value or earnings.

  • Choosing a valuation model by habit instead of by company features.

    Fix: Match the model to the facts: no dividends, negative free cash flow, or reliable book values point toward residual income.

Last-day revision: Residual Income Valuation

  • Equity charge = cost of equity × beginning book value of equity.
  • Residual income = net income − equity charge.
  • RI also equals (ROE − cost of equity) × beginning book value.
  • Intrinsic value = current book value + present value of expected future RI.
  • Positive RI means the firm earns above its cost of equity, so value exceeds book value.
  • Book value rolls forward as beginning book value + net income − dividends under clean surplus.
  • Persistence factor between 0 and 1 shows how fast abnormal RI fades; higher means slower fade.
  • Sustainable growth rate = retention rate × ROE.
  • Terminal value choice often drives most of the estimate, so check the assumption in the vignette.
  • Clean surplus is violated when items bypass net income and go straight to equity, so adjust earnings or book value.
  • RI suits firms with no dividends or negative free cash flow, if accounting quality is good.
  • Weak accounting quality or heavy non-recurring items make RI less reliable.

Residual Income Valuation in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Residual Income Valuation: frequently asked questions

What is residual income in equity valuation?

It is net income less a charge for the cost of equity capital, calculated as cost of equity times beginning book value. It shows the profit earned above what shareholders require. A positive value means the firm is adding value beyond its equity capital.

How is the residual income model different from the dividend discount model?

The dividend discount model values the stock from expected dividends. The residual income model starts from book value and adds the present value of expected residual income. It can work when a firm pays no dividends, as long as earnings and book value are reliable.

Do I need to memorise the clean surplus relation?

Yes, know it in words and in the formula: ending book value equals beginning book value plus net income minus dividends. The exam can ask what happens when items bypass the income statement. Be ready to explain how that affects the RI estimate.

How should I practise this chapter for the item-set format?

Use full vignettes, not isolated formulas. Mark the inputs and their dates as you read, then solve all four questions. Review any mistake by finding which input or assumption you misread.