The Residual Income Model (RIM), similar to the Dividend Discount Model (DDM) or the Discounted Cash Flow (DCF) approach, is a method of company valuation. Unlike these models, the RIM focuses on whether a company earns profits that exceed its cost of equity.
This shows whether a company truly creates value for its shareholders and helps investors assess whether a stock is overvalued or undervalued.
The Residual Income Model (RIM) is used to determine the intrinsic value of a company’s equity. It is based on the concept of residual income, the portion of profit that remains after deducting the cost of equity.
The cost of equity reflects the return investors expect as compensation for the risk of owning the company’s shares. Residual income helps assess whether a company earns more than its cost of capital and therefore creates real value for its shareholders.
The calculation follows two steps. The first step is to determine the residual income for each year.
The formula for the Residual Income Model is:
Residual Income = Net Income – Equity Charge
Where: Equity Charge = BV of Equity × Cost of Equity
Once the residual incomes for each period have been calculated, the value of equity (V) can be determined. The Residual Income Model (RIM) assumes that this value equals the book value of equity plus the present value of all future residual incomes.
The following formula summarizes this concept:
Where:
The following example illustrates how the Residual Income Model (RIM) is applied in practice. Step by step, it shows how the company’s equity value is derived from the book value of equity and the present value of future residual incomes, starting with the cost of equity.
Assume the following data:
In the first step, the required return on the company’s equity is calculated. This amount will later be subtracted from the net income to determine the residual income.
The residual income shows how much profit remains after subtracting the cost of equity.
To calculate the total value, future residual incomes are discounted back to their present value.
Instead of forecasting each year separately, it is assumed that the residual incomes grow by 3 % per year. This assumption represents a simplified yet common approach in practice, as constant growth makes the calculation much easier and is frequently used in valuation models. Using a growth formula, the value of all future residual incomes can be determined at once:
The current book value and the present value of residual incomes together make up the estimated intrinsic equity value of the company.
The company’s intrinsic equity value is therefore $722.2 M.
The Residual Income Model (RIM) is particularly useful when a company does not pay dividends or when future cash flows are difficult to forecast. In such cases, it provides a practical way to determine a company’s value.
While the Dividend Discount Model (DDM) is based on dividends and the Discounted Cash Flow (DCF) approach relies on long-term cash flow projections, the RIM uses accounting figures such as the book value of equity and net income.
The following chart illustrates this difference:
A major advantage of the Residual Income Model (RIM) is that it is less sensitive to uncertain forecasts. The model can be applied even when future cash flows are difficult to predict, for example in companies with volatile earnings or a strong dependence on economic conditions.
However, this requires reliable and transparent financial statements Because the valuation is based on the book value of equity, its accuracy strongly depends on the quality of the reported data.
The Residual Income Model (RIM) is particularly common in the banking and insurance industries, where financial statements tend to be highly reliable due to strict regulation and regular audits. These sectors rely heavily on measurable indicators such as equity and net income, while dividends and cash flows often fluctuate and are harder to predict. As a result, the RIM offers a stable and practical way to assess value, especially when traditional methods like DDM or DCF are less reliable.
Like any valuation tool, the Residual Income Model has distinct advantages and limitations.
| Strengths of the RIM | Weaknesses of the RIM |
| Works well even when dividends or cash flows are hard to forecast | Dependent on accounting numbers, which can be manipulated |
| Relies on information from financial statements, usually easy to access | Requires estimating the cost of equity, which is subjective |
| Can be applied even if Free Cash Flow is negative | Highly sensitive to long-term growth assumptions |
| Explicitly factors in the cost of equity and shows whether a company is creating value for shareholders | Less effective for asset-light firms with significant intangibles |
Here are some of the most common interview questions about the Residual Income Model to help you practice.
Residual income shows how much profit a company earns after subtracting the return expected by investors. In other words, it measures the value created beyond the required minimum return.
In contrast, net income is the company’s total profit for the year and does not take into account that shareholders’ equity also carries an expected return.
Industries such as banking and insurance are particularly well suited for the Residual Income Model (RIM), as their balance sheet data are highly regulated, transparent, and reliable. Their business models are based on clearly measurable financial indicators such as equity and profit, while cash flows and dividends often fluctuate and are difficult to predict. This makes it possible to estimate a company’s value using the RIM more accurately and consistently than with other valuation approaches.
The Residual Income Model (RIM) is particularly useful when cash flows or dividends are difficult to forecast or fluctuate significantly over time. In such cases, DCF or DDM analyses often produce unstable results, as they depend on reliable projections of distributions or cash flows.
The RIM provides a more practical alternative, since it relies on book values and earnings, which are generally easier to predict and more readily available.
The result of the Residual Income Model (RIM) represents the intrinsic value of a company’s equity. This value can be compared to the current market price to assess whether a stock is overvalued or undervalued. If the calculated intrinsic value is higher than the market price, the stock may be undervalued; if it is lower, the stock could be overvalued.
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The Residual Income Model (RIM) estimates the intrinsic value of a company’s equity by adding the present value of future residual incomes to the current book value of equity.
Residual income is calculated as net income minus the cost of equity and shows whether a company earns more than the minimum return expected by investors.
The model is particularly useful when no dividends are paid, when cash flows are difficult to forecast, or when reliable balance sheet data are available - for example, in the banking and insurance sectors.
One advantage of the RIM is that it relies on accounting figures that are easy to obtain and makes value creation beyond net income visible. However, its accuracy depends on the quality of financial statements and on the assumptions regarding the cost of equity and long-term growth.
