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What is Residual Income Model

Chapter 1
International Financial Reporting Standards and New Directions in Earnings Management
Is an approach to equity valuation that formally accounts for the cost of equity capital. Here, “residual” means in excess of any opportunity costs measured relative to the book value of shareholders' equity; residual income is then the income generated by a firm after accounting for the true cost of capital.
Published in Chapter:
Earnings Quality and Firm Valuation: A “New” Perspective Deriving From the Literature
Liliana Marques Pimentel (University of Coimbra, Portugal) and Susana Margarida Faustino Jorge (University of Coimbra, Portugal)
Copyright: © 2019 |Pages: 31
DOI: 10.4018/978-1-5225-7817-8.ch001
Abstract
The quality of earnings is a summary metric in firm performance evaluation and a focal question to assess the quality of accounting information. A high-quality earnings figure will reflect a firm's current operating performance, being a good indicator of future operating performance; it also accurately annuitizes the intrinsic value of the firm. The multidimensional nature of the earnings quality (EQ) concept has given form to a multiplicity of constructs and measures. This chapter offers a systematic literature review on EQ and its implication on firm value. On the one hand, it discusses the different existent definitions of EQ and the multidimensional nature of the concept; on the other hand, it highlights a “new” EQ perspective taking into account the virtuosities of the residual income model. An empirical model is proposed that reinterprets rebuilding the linear information dynamics in relation to market value added and captures, in a composite measure, the three-dimensional facet of the EQ concept: persistence, predictability, and informativeness of earnings.
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