Equivalent valuations in cash ﬂow and accounting models
Richard J. Sweeney
Published online: 11 January 2013
Ó Springer Science+Business Media New York 2013
Abstract This paper investigates the equivalence of equity valuation between the free cash
ﬂow model and the residual income model. Two conditions are found to be jointly sufﬁcient
for Residual Income and Free Cash Flow models to produce the same equity valuation: (a) the
models’ discount rates jointly satisfy the Modigliani and Miller (Am Econ Rev 48:261–297,
1958) condition which relates discount rates for levered equity, unlevered equity, tax savings
and debt, and (b) forecasts of the two models’ variables jointly satisfy the income statement
and balance sheet identities. Past discussions fail by ignoring or misusing (a).
Keywords Cash-ﬂow valuation models Á Residual income models Á Dividend discount
rates Á Accounting identities
JEL Classiﬁcation G11 Á C52 Á M41
Accrual-accounting and cash-ﬂow valuation models are both popular. Among accounting
valuation models, Residual Income (RI) models of equity value have received important
and are the basis of much empirical research.
Further, there is much
interest in the related Economic Value Added
(EVA) and other accounting-based
approaches to measuring proﬁts, particularly as related to managers’ incentives.
R. J. Sweeney (&)
McDonough School of Business, Georgetown University, 37th and ‘‘O’’ Sts. NW, Washington, DC
See Ohlson (1995), Ohlson and Zhang (1998), Feltham and Ohlson (1999), Ohlson (2000, 2001).
See Dechow et al. (1999), Myers (1999a, b), Nissim and Penman (2001), Penman and Sougiannis (1998),
Francis et al. (2000), Sougiannis and Yaekura (2001), Callen and Morel (2001), Baginski and Wahlen
(2003), O’Hanlon and Peasnell (2003), Ali et al. (2003), Bradshaw (2004), Beynon and Clatworthy (2012).
See Grifﬁth (2004), Ittner and Larcker (2001), Jensen (2001), O’Hanlon and Peasnell (1998, 2002),
Rev Quant Finan Acc (2014) 42:29–49