Page 35 - FINAL CFA II SLIDES JUNE 2019 DAY 8

LOS 32.i: Compare residual income models to
dividend discount and free cash flow models. READING 32: RESIDUAL INCOME VALUATION

• DDM and FCFE models measure value by discounting a stream of expected MODULE 32.5: STRENGTHS/WEAKNESSES
cash flows.
• The RI model starts with a BV and adds to this the PV of the expected stream
of residual income.

Theoretically, both should agree if the underlying forecast assumptions forecasts are same. In reality, however, we had forecast
all of the common inputs with the same degree of accuracy, and the different models yield different results.

Helpful to use both sets to assess the consistency of results; if dramatically different estimates, check underlying assumptions.

LOS 32.j: Explain strengths and weaknesses of residual income models and justify the selection of a residual
income model to value a company’s common stock.

Strengths -
• Terminal value does not dominate the intrinsic value estimate, as is the case with DD and FCF valuation models.
• Use accounting data, which is usually easy to find.
• Applicable to firms that do not pay dividends or that do not have positive expected FCFS in the short run.
• Applicable even when cash flows are volatile.
• Focus on economic profitability rather than just on accounting profitability.

Weaknesses -
• Rely on accounting data that can be manipulated by management.
• Reliance on accounting data requires numerous and significant adjustments.
• Assume that the clean surplus relation holds or that its failure to hold has been properly taken into account.
• The clean surplus relation can be expressed as B = B − + E − D , which means that Ending BVe = Beginning BVe
t 1
t
t
t
plus Earnings less Dividends, excluding ownership transactions. Any accounting charges that are taken directly to
the equity accounts (such as currency translation gains and losses) will cause the clean surplus relation not to hold).