Analyst's Toolkit: Wal-Mart's Residual Income

Return on equity is an oft-touted factor in making investment decisions. While it shows shareholders' total returns, it fails to consider investors' required return. A measure known as residual income adjusts for the required return. That can help investors determine which investments offer the best returns over the minimum required.

In industries with several strong players, returns on equity may not provide accurate differences among the companies. Stores such as Wal-Mart(WMT Quote), Target(TGT Quote) and Costco(COST Quote) look solid, but determining which will compensate its shareholders the most can be learned by using residual income.

The theory behind residual income is that a firm's net income doesn't account for the cost of equity funding the company's operations. As a result, return on equity actually could be below the return required by investors given the level of risk. In that case, the company is failing to generate sufficient profits to compensate equity holders.

Adjusting for this fault is simple. Since earnings per share can be backed into by multiplying the return on equity by the book value per share, and the cost of equity per share can be understood by multiplying the required return by the book value per share, the difference between earnings per share and the cost of equity per share results in residual income.

More simply, the equation can be written the following way:

Residual income = (return on equity - required return) x book value per share.

Applying this formula to retail stocks results in the following:

Wal-Mart Target Costco ROE Required Return 21.10% 15.00% 11.90% Required Return 4.80% 11.00% 8.40% Difference 16.30% 4.00% 3.50% Book Value $15.88 $18.23 $20.99 Residual Income $2.59 $0.72 $0.73 Source: Bloomberg & TheStreet.com Ratings