Economic profit

Residual income valuation: OCI and clean surplus accounting

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Considering the market’s focus on earnings, other comprehensive income (OCI) can be easily overlooked by investors. We think OCI is always important in equity analysis, but if you use a residual income approach to valuation the requirement for a ‘clean surplus’ in your model makes it vital to consider gains and losses reported outside profit and loss.

We explain clean surplus accounting and why residual income valuations only work if your forecast financial statements meet the clean surplus condition. One aspect of financial reporting where this may be particularly important is expected currency translation differences.

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DCF versus residual income: A difference in returns

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Residual income based valuations are a useful alternative to the more common discounted cash flow. While both approaches must produce the same answer for a given set of assumptions and value drivers, we think it can be easier to derive realistic inputs using the residual income approach, considering the focus on return on investment.

However, residual income also poses challenges. The approach requires ‘clean surplus’ accounting, return inputs must allow for accounting distortions due to the lack of recognition of intangibles, and terminal growth assumptions may need to differ from those used in DCF – as we demonstrate using an interactive model.

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