Residual Income Valuation in Relation to Other Approaches

Valuation choices matter. Just think of how'd you value Prost Motors, a car manufacturer. Prost has free cash flow, pays a dividend, and has residual income. So its equity value can be calculated multiple ways. But each valuation model takes in different inputs in order to compute an intrinsic value. So each value would be different, right?

Actually, the values should theoretically be the same!

That's right!

Between the three models—free cash flow, DDM, and residual income—each one should hypothetically yield the same total value. That's because each calculates the respective value that should be available to equity shareholders, though in certain situations the value might differ given a company's priorities and funding. While the DDM and free cash flow models forecast future cash flows and find the value by discounting those flows back to the present value, the residual income model starts with the book value of equity and adds the present value of future residual income.

So the models differ but yield similar results. But the descriptions highlight a key difference in the timing of value recognition. And one in particular recognizes a smaller portion of earnings in future periods. Which one would that be?

Actually, no. As dividends grow in the future, the estimated terminal value will grow as well. So the value is realized in future periods.

That's not it. In most cases, free cash flow to equity grows indefinitely, so the terminal value will make up the majority of the value.

Bingo! The residual income model realizes most of the value in the initial period through book value, so the later periods don't realize as much value. And this early recognition is a practical advantage of the residual income model versus the other valuation models. Why do you think that's the case?

That's it! The terminal value has substantial uncertainty because it typically has an infinite time period. So as you can imagine, there's a wide range of possibilities. But that's not the only strength of the residual income model. Think back to the accounting equation for residual income. $$\displaystyle \mbox{Residual Income} = \mbox{Net Income} - \mbox{Equity Charge}$$ What would be another advantage of this model?

No. The residual income's value comes from the book value and initial residual value.

No, actually. The cash flows don't always make up the large portion of the value.

You got it! And really, all three are advantages of the residual income model. It uses accounting data and it can be applied to companies with no cash flows or dividends or when cash flows are unpredictable. And it focuses on economic profitability. So there are lots of advantages. But that means there are also some disadvantages.

One disadvantage of the residual income model is that the accounting data that's used in the equation can be manipulated and may also require significant adjustments. But that's not all. The residual income model requires clean surplus accounting or else specific adjustments will need to be made. And the cost of debt is assumed to be reflected by interest expense, but that's not always the case.

So knowing those strengths and weaknesses will help determine which model is most appropriate for the given company. Think back to Prost Motors. It has dividends, cash flows, and residual income. Which model is best to value its equity?

Yes! Really, it's any of the three models! But since residual income takes a different calculation approach, it's a great way to assess the consistency of the valuation calculated by the other models. So it's a good choice for companies like Prost, even if it didn't pay dividends, had free cash flows predicted during the forecast period, or had an uncertain terminal value. But in other cases, the residual income model isn't the best choice. If Prost had significant clean surplus accounting issues or if book value or ROE weren't predictable, then the other models would be better.

To summarize: [[summary]]

No

Yes

DDM

Residual income

Free cash flow to equity

The terminal value of the DDM and free cash flow has substantial uncertainty

The residual income model's terminal value has a large impact on the valuation

The cash flows of the DDM and free cash models make up a large portion of the valuation

It uses easily accessible accounting data

It can be used when cash flows are unpredictable

It can be applied to companies with no dividends or little cash flow

DDM

Residual income

Free cash flow to equity

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