Identifying Incorrect Statements in Residual Income Models

Very Hard Equity Valuation Techniques Residual Income Models

XYZ Ltd. is currently evaluating its equity valuation using the Residual Income Model (RIM). The company has a book value of equity of $2,000,000 and expects its net income for the upcoming year to be $250,000. The company's required return on equity (r) is 12%. Given these values, the Residual Income for XYZ Ltd. in the next year can be calculated as the difference between the net income and the equity charge. However, to summarize the company's valuation accurately, we must determine which of the following statements about the RIM and its application is incorrect.

The Residual Income Model requires forecasting the net income and calculating the equity charge for each year.

The intrinsic value derived from the RIM can sometimes indicate a stock is undervalued when its market price is above the calculated intrinsic value.

A positive residual income indicates that the company is generating returns above the required rate of return.

Hint

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