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Subject 7. Residual Income Valuation in Relation to other Approaches PDF Download
An analyst should use RI model alongside DDM or FCFE, and choose the best model based on the specifics of the company.

  • If he can predict future dividends with reasonable certainty, he can use DDM.
  • Residual income model is preferable in case of unpredictable future cash flows.
  • When cash flows are predictable, but the company is not expected to start paying dividends in the near future, FCFE model should be used for valuation.

The theoretical intrinsic value of the company's stock is independent of the model used. The difference lies in the form and time of value recognition.

  • To calculate the stock's value using the DDM or FCFE models, analysts forecast each future cash flow or dividend and then discount them to find the total present value.
  • Residual income model starts with the current book value and adjusts it by the present value of future economic earnings.

Theoretically, values should be the same if inputs used are the same. However, it's difficult to forecast all of the inputs and models usually yield different results.

Strengths and Weaknesses of the Residual Income Model

Strengths:

  • Intrinsic value depends less on the terminal value, relative to other models.
  • The RI model uses available accounting data.
  • It is applicable for non-dividend-paying firms, firms with negative or highly volatile free cash flows.
  • The model addresses directly economic rather than accounting profitability of investments in the company.

Weaknesses:

  • It may require accounting adjustments.
  • Earnings are subject to management manipulation of accounting data.
  • The clean surplus relation (BVt = BVt-1 + Et - Dt) must hold for the RI model to be theoretically accurate. If this relationship is violated, an analyst has to adjust accounting data appropriately.

When to use the RI model:

  • If terminal values cannot be determined with sufficient probability.
  • If a company retains all its earnings, or dividend payout cannot be predicted.
  • If the free cash flows in the near future are either negative or unpredictable.

When not to use the RI model:

  • There are significant departures from clean surplus accounting. For example,

    • Gains on marketable securities are reflected in stockholder's equity as "comprehensive income" rather than as income on the income statement.
    • Wide use of employee stock options.
    • Foreign currency translations.
    • Some pension adjustments.

  • Determinants of residual income (e.g., book value and ROE) are not predictable

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