When interviewers ask how to value a bank, a fresh DCF template is often the wrong tool to reach for. Free cash flow, the backbone of a standard discounted cash flow model, doesn't translate cleanly to a business whose "cash flow" is really a function of regulatory capital, deposit funding, and loan origination rather than capex and working capital. That gap is exactly where the Residual Income Model (also called the Economic Value Added, or EVA, approach) earns its place in a candidate's toolkit.
What Residual Income Actually Measures
Residual income is the profit a company generates above and beyond what its equity investors could otherwise expect for bearing the same risk. Instead of forecasting cash flows, the model starts with two figures nearly every company reports cleanly: net income and book value of equity.
RI_t = NI_t - (Re x BVE_(t-1))
Where Re is the cost of equity and BVE is the book value of equity at the start of the period. The second term — the capital charge — is the crucial piece: it's the return shareholders require just to be compensated for the equity capital tied up in the business. Net income that clears the capital charge is genuine value creation. Net income that doesn't is value destruction, even if the headline profit number is growing.
Why It Beats a DCF for Banks and Capital-Intensive Businesses
A standard unlevered DCF needs a coherent definition of free cash flow: EBIT, less taxes, less reinvestment (capex and working capital), plus D&A. For an industrial or software company, that's a fairly intuitive exercise. For a bank, it breaks down almost immediately — a bank's balance sheet is its operating asset, loans are both the "product" and the "capex," and capital levels are set by regulators (Basel requirements, stress-test buffers) rather than by management's investment appetite.
Residual income sidesteps the problem entirely. It never asks "what is free cash flow?" — it only needs net income and book equity, both of which are already reported under a clean, comparable set of accounting rules. That's why residual income and dividend discount models are the standard toolkit for valuing banks and insurers, while a plain unlevered DCF is reserved for businesses with a genuine reinvestment cycle.
The Cost of Equity, Not WACC
One detail trips up a lot of candidates: the discount rate in a Residual Income Model is the cost of equity (Re), not WACC. That's because residual income is already an equity-level profit measure — net income is what's left after interest expense to debtholders, so there's no need (and no correct way) to discount it at a blended, capital-structure-weighted rate. If you're comfortable unlevering and relevering beta to get to a cost of equity in the first place, the case on WACC with Leverage is good practice for that exact input.
A Built-In Sanity Check
The model has a useful property worth remembering for an interview: if a company's return on equity exactly equals its cost of equity in every period, residual income is zero throughout, and the model collapses to Equity Value = Book Value of Equity. Any valuation above book implies the market expects the company to earn above its cost of equity going forward; any valuation below book implies expected value destruction. It's a quick way to check whether your numbers are plausible without redoing the whole calculation.
For a full worked example — projecting net income and book equity forward, computing residual income and its capital charge year by year, and discounting a terminal value back to a final equity value for a bank — walk through the Residual Income Model interview case.