"Walk me through a Residual Income valuation" is a question that catches candidates who only know how to build a DCF. The good news: once you know the four steps, it's a shorter, more mechanical model than a DCF — no free cash flow build, no separate treatment of capex or working capital. Here's how to answer it cleanly in an interview.

Step 1: Roll Forward Book Value of Equity

Start with the current book value of equity (BVE0) and roll it forward year by year, assuming the clean surplus relation holds: all net income is retained, with no dividends or buybacks touching the balance.

BVE_t = BVE_(t-1) + NI_t

Say it out loud in the interview — naming the clean surplus assumption up front shows the interviewer you understand why the roll-forward is valid, and flags the adjustment you'd need to make if the company actually pays dividends.

Step 2: Compute Residual Income Each Year

RI_t = NI_t - (Re x BVE_(t-1))

This is the step interviewers care about most. Net income minus the capital charge (cost of equity times the beginning-of-period book value — a common mistake is using the ending balance instead). Talk through what the number means as you calculate it: residual income isolates the profit that actually clears the shareholders' required return, which is a different question from "is net income growing?"

Step 3: Discount Each Year's Residual Income at the Cost of Equity

PV(RI_t) = RI_t / (1 + Re)^t

Use the cost of equity (Re), not WACC — a frequent slip, since most other valuation cases on this site (like WACC with Leverage) train you to reach for WACC by reflex. Residual income is already an equity-level number, so equity is also the correct discount rate.

Step 4: Add a Terminal Value and Sum to Equity Value

Beyond the explicit forecast, apply a Gordon growth perpetuity to the final year's residual income, discount that back to the present, and add everything — including the starting book value — together:

TV_3 = [RI_3 x (1 + g)] / (Re - g)

Equity Value = BVE0 + Sum of PV(Residual Income) + PV(Terminal Value)

One thing worth flagging to an interviewer: because residual income is a shrinking excess-return figure rather than a growing cash flow figure, the terminal value in this model is typically far less sensitive to your growth assumption than a DCF terminal value would be — a genuine advantage when your MD starts stress-testing your terminal growth rate.

Common Ways This Goes Wrong

Watch for: discounting at WACC instead of the cost of equity, using the wrong period's book value in the capital charge, forgetting to discount the terminal value back to present, and breaking the clean surplus assumption without adjusting for it. All four show up regularly when candidates rush through this model.

For the fully worked numbers — a three-year forecast, year-by-year residual income and capital charge table, and a final equity value — see the complete Residual Income Model case walkthrough. If the underlying cost-of-equity mechanics feel shaky, it's worth reviewing WACC with Leverage or the broader valuation methodology cases first.