Purpose of Residual Income Model in Equity Valuation

Residual income models are a widely used method for valuing equity by assessing the earnings generated above the required return on equity. These models help investors determine whether a stock is overvalued or undervalued based on the expected residual income. To calculate residual income, the formula typically used is:

Residual Income = Net Income - (Equity Charge)

Where the equity charge is defined as the equity capital multiplied by the cost of equity. Understanding this model is key to analyzing a company’s performance in relation to its cost of equity.

Given this context, what is the primary purpose of using the Residual Income Model in equity valuation?