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/FCFE models discount a future a stream of expected cash flows, MODULE 32.5: STRENGTHS/WEAKNESSES
including terminal value and RI models discount expected residual income
(rather including CRI) but includes BV, whilst when DDM/FCF do not!

Theoretically, both should agree if the underlying forecast assumptions forecasts are same. It is always helpful to use both to
assess the consistency of results; if dramatically different estimates, check underlying assumptions.

LOS 32.j: Explain strengths and weaknesses of RI models and justify the selection 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.
• Uses accounting data, which is usually easy to find.
• Helps if No dividends or if negative FCFS in the short run or when cash flows are volatile!
• Focuses on economic profitability rather than just on accounting profitability.

Weaknesses -
• Rely on accounting data that can be manipulated by management.
• From net income to NOPAT need numerous and significant adjustments.
• Assumes clean surplus relation holds or that its failure to hold has been properly taken into account.
It needs a clean B = B − + E − D but IFRS/US GAAP requires certain accounting charges (such as currency
t 1
t
t
t
translation gains and losses) which violates this!