Reconciling Value Estimates from the Discounted Cash Flow Model and the Residual Income Model *

Reconciling Value Estimates from the Discounted Cash Flow Model and the Residual Income Model * This paper examines why practitioners and researchers get different estimates of equity value when they use a discounted cash flow (CF) model versus a residual income (RI) model. Both models are derived from the same underlying assumption — that price is the present value of expected future net dividends discounted at the cost of equity capital — but in practice and in research they frequently yield different estimates. We argue that the research literature devoted to comparing the accuracy of these two models is misguided; properly implemented, both models yield identical valuations for all firms in all years. We identify how prior research has applied inconsistent assumptions to the two models and show how these seemingly small errors cause surprisingly large differences in the value estimates. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Contemporary Accounting Research Wiley

Reconciling Value Estimates from the Discounted Cash Flow Model and the Residual Income Model *

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Publisher
Wiley
Copyright
2001 Canadian Academic Accounting Association
ISSN
0823-9150
eISSN
1911-3846
D.O.I.
10.1506/W13B-K4BT-455N-TTR2
Publisher site
See Article on Publisher Site

Abstract

This paper examines why practitioners and researchers get different estimates of equity value when they use a discounted cash flow (CF) model versus a residual income (RI) model. Both models are derived from the same underlying assumption — that price is the present value of expected future net dividends discounted at the cost of equity capital — but in practice and in research they frequently yield different estimates. We argue that the research literature devoted to comparing the accuracy of these two models is misguided; properly implemented, both models yield identical valuations for all firms in all years. We identify how prior research has applied inconsistent assumptions to the two models and show how these seemingly small errors cause surprisingly large differences in the value estimates.

Journal

Contemporary Accounting ResearchWiley

Published: Jun 1, 2001

References

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