Residual income model

A residual income model, also called an economic profit model, values a company by starting from its book value of equity, what's already on the balance sheet, then adding the present value of the profit it's expected to earn above what shareholders require for supplying that capital.

A company earning exactly its required return, net income equal to that equity charge, produces zero residual income even though it's profitable in the ordinary sense. Residual income is a stricter bar than plain profitability: it asks whether a business is creating value on top of its cost of capital, not simply whether it made money.

This approach is used most for businesses where free cash flow is hard to define cleanly, a bank or insurer, where concepts like capital expenditures and working capital don't map onto the business the way they do for a manufacturer or retailer, but where book value and net income are both reported cleanly and consistently.