8.18  Interpreting Residual Income

The above permits an alternative view of Residual Earnings which highlights the understanding of residual earnings.  Residual income is dollar excess return over what is required by investors in terms of the cost of equity capital times book value of shareholders equity.

Residual Earningst = (Return on Common Equityt – Cost of equity capital) * Book value of common equityt-1

Residual Income2010 =  (0.5029 – 0.0837)*16.881 = 7.0771

Residual Income2011 =  (0.4043 – 0.0837)*22.968 = 7.3656

Calculating the Present Value of Residual Earnings over the Stage 1 Growth Phase

The cost of equity capital equals the investors’ required rate of return.  In turn this equals the discount rate for computing the present value of the residual earnings over the Stage 1 growth phase.    You can verify the above as follows:

Present Value Stage 1 phase Residual Income = 30.7233 = 7.0771/(1.0837) + 7.3656/(1.0837^2) + 7.7769/(1.0837^3) + 8.2312/(1.0837^4) + 8.7328/(1.0837^5)