The document discusses equity valuation using the residual income model (RIM). It introduces key concepts like residual income (RI), which is the difference between net income and a charge for invested capital. The RI of a company is discounted back to arrive at its value. RIM uses economic profit rather than accounting metrics and assumes RI will tend to zero in the long run with no terminal value. RIM is useful when a company's accounting data is unreliable or it doesn't pay dividends or generate positive cash flow. The document provides an example of evaluating hotel investment opportunities in Dubai and Monte Carlo using return on investment before recommending the Dubai location.

1. Equity Valuation. The skill to select winners.
Residual Income Model
Residual Income Model
Measuring expectations vs. reality

2. Stock’s Fundamental Value – Short-term
Market
Price
Stock’s
Value
Equity Valuation. The skill to select winners.
Residual Income Model

3. Why the short term distortions exist?
Equity Valuation. The skill to select winners.
Residual Income Model
Market does not reflect all available information
Short-term performance is different than the expectation

4. How we measure results from investment?
Equity Valuation. The skill to select winners.
Residual Income Model
𝑅𝑂𝐼 =
𝐼𝑛𝑐𝑜𝑚𝑒
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

5. Slide: 5/52
Why ROI is important?
Manager of hotel chain is considering opening in Dubai (UAE) or
Monte Carlo (France). Preliminary calculation say that hotel in
Dubai will cost $350mln. and will have net income per year
$25mln. The property in Monte Carlo will take $450mln. to open
and will get $30mln. per year. What will you advise this
manager?

6. Slide: 6/52
Why ROI is important?
Manager of hotel chain is considering opening in Dubai (UAE) or
Monte Carlo (France). Preliminary calculation say that hotel in
Dubai will cost $350mln. and will have net income per year
$25mln. The property in Monte Carlo will take $450mln. to open
and will get $30mln. per year. What will you advise this
manager?
Dubai: 𝑅𝑂𝐼 =
25
350
= 7.14% - winner
Monte Carlo: 𝑅𝑂𝐼 =
30
450
= 6.66%
Equity Valuation. The skill to select winners.
Residual Income Model

7. Risk premium and Opportunity cost
Equity Valuation. The skill to select winners.
Residual Income Model
Opportunity costs represent the benefits an individual, investor or
business misses out on when choosing one alternative over another.
What are opportunity costs when investing in stock market?
Equity risk premium

8. Risk premium
Equity Valuation. The skill to select winners.
Residual Income Model
What is the risk premium?
“the minimum amount of money by
which the expected return on a risky
asset must exceed the known return
on a risk-free asset in order to induce
an investor to hold the risky asset
rather than the risk-free asset.”

9. Slide: 9/52
Why ROI is important?
Manager of hotel chain is considering opening in Dubai (UAE) or
Monte Carlo (France). Preliminary calculation say that hotel in
Dubai will cost $350mln. and will have net income per year
$25mln. The property in Monte Carlo will take $450mln. to open
and will get $30mln. per year. What will you advise this
manager?
Dubai: 𝑅𝑂𝐼 =
25
350
= 7.14% - winner
Monte Carlo: 𝑅𝑂𝐼 =
30
450
= 6.66%
Equity Valuation. The skill to select winners.
Residual Income Model

10. Slide: 10/52
Why ROI is important?
Manager of hotel chain is considering opening in Dubai (UAE) or
Monte Carlo (France). Preliminary calculation say that hotel in
Dubai will cost $350mln. and will have net income per year
$25mln. The property in Monte Carlo will take $450mln. to open
and will get $30mln. per year. What will you advise this
manager?
Dubai: 𝑅𝑂𝐼 =
25
350
= 7.14% − 10% = −2.86%
Monte Carlo: 𝑅𝑂𝐼 =
30
450
= 6.66% − 6% = 0.66% - winner
Equity Valuation. The skill to select winners.
Residual Income Model

11. Concept of economic profit in firms
Equity Valuation. The skill to select winners.
Residual Income Model
Accounting
Profit
Income
Opportunity
Costs
Accounting
Profit
Expenses
Economic
Profit

12. Value added
Equity Valuation. The skill to select winners.
Residual Income Model
If Economic profit > 0
If Economic profit < 0
Value Added
Loss of Value

13. Residual Income
Equity Valuation. The skill to select winners.
Residual Income Model
𝑅𝐼𝑡 = 𝑁𝐼𝑡 − 𝐵𝑉𝑡 ∗ 𝑘 𝑒
or
𝑅𝐼𝑡 = 𝑅𝑂𝐸 − 𝑘 𝑒 ∗ 𝐵𝑉𝑡

14. Residual Income
Equity Valuation. The skill to select winners.
Residual Income Model
𝑅𝐼𝑡 = 𝑁𝐼𝑡 − 𝐵𝑉𝑡 ∗ 𝑘 𝑒
or
𝑅𝐼𝑡 = 𝑅𝑂𝐸 − 𝑘 𝑒 ∗ 𝐵𝑉𝑡
Accounting
Profit

15. Residual Income
Equity Valuation. The skill to select winners.
Residual Income Model
𝑅𝐼𝑡 = 𝑁𝐼𝑡 − 𝐵𝑉𝑡 ∗ 𝑘 𝑒
or
𝑅𝐼𝑡 = 𝑅𝑂𝐸 − 𝑘 𝑒 ∗ 𝐵𝑉𝑡
Accounting
Profit
Capital
Charge

16. Valuation using RI
Equity Valuation. The skill to select winners.
Residual Income Model
𝑉𝑒 =
𝑅𝐼𝑡
1 + 𝑘 𝑒
𝑡
+ 𝐵𝑉

17. Key differences between RIM and DCF
Equity Valuation. The skill to select winners.
Residual Income Model
RIM uses economic profit rather than accounting metrics;
In long-term RI tends to 0;
There is no terminal value.

18. When to use RIM?
Equity Valuation. The skill to select winners.
Residual Income Model
Troubles with
accounting data
Company does
not pay dividends
Company does
not generate
positive cash flow

19. Thank your for your attention!
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Equity Valuation. The skill to select winners.
Residual Income Model