Advantages and disadvantages of residual income

Disadvantages of residual income - As you can see from the above example, using the concept of residual income, although company x is reporting a profit on its income statement (which it should), once its cost of equity is included in relation to its return to shareholders, it is actually economically unprofitable based on the given level of risk. The biggest drawback of the residual income method is the fact that it relies so heavily on forward looking estimates of a firm's financial statements, leaving forecasts vulnerable to psychological biases or historic misrepresentation of a firms financial statements. The intrinsic, or fair value, of a company's stock using a the residual income approach can be broken down into its book value and the present values of its expected future residual incomes, as illustrated in the formula below. On the plus side, residual income models make use of data readily available from a firm's financial statements and can be used well with firms who do not pay dividends or do not generate positive free cash flow.

Residual Income Advantage

Short video on the advantages of residual income time sales.