Definition of residual income
Residual income can be used in a personal finance context to express a person's disposable income after paying all loans, bills and other necessary expenses. It is used to calculate their suitability for taking out, or increasing, loans or mortgages.
The term residual income is also used when calculating the value of a company or stock.
The residual income valuation model is net income less a charge (deduction) for common shareholders' opportunity cost in generating net income. It is the residual or remaining income after considering the costs of all of a company’s capital.
Why is residual income used in company valuations?
Analysts frequently use this valuation model because although traditional accounting includes a charge for the cost of debt capital, it does not account for the cost of equity capital (such as dividend payouts or other equity costs). A company, therefore, might be reporting positive net income, but may not be adding value for shareholders if it does not earn more than its cost of equity capital. Residual income models recognise the costs of all the capital used in generating income.