Contrast residual income models with free cash flow and dividend discount models
The idea
Residual income, dividend and free cash flow models are all present value approaches, and with consistent assumptions they should give the same value. They differ in when value is recognised. Dividend and cash flow models put much of the value in the terminal value, far in the future, where uncertainty is greatest. The residual income model starts with current book value and adds the present value of excess earnings, so more value is recognised immediately and the estimate depends less on the terminal value. Residual income relies on accounting data, so it is exposed to accounting choices, while cash flow models are less so. The trap is thinking the models measure different things, when they allocate the same value differently over time.
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- Work out economic value added, market value added and residual income and explain what they mean
- Explain what residual income models are used for
- Value a common share with the residual income model and contrast when value is recognised under it and under other present value models
- Explain the fundamentals that determine residual income
- Explain how residual income valuation links to the justified P/B ratio derived from forecasted fundamentals
- Work out a common share's intrinsic value with residual income models that have one constant-growth stage or several stages, and explain the result
- Back out the growth rate implied in residual income from the market P/B ratio and an estimated required return on equity
- Explain continuing residual income and defend an estimate of it at the forecast horizon in light of the firm's and industry's outlook
- Explain where residual income models are strong and weak and argue for using one to value a firm's common stock
- Set out the accounting problems that arise when residual income models are applied