Equivalence between Discounted Cash Flow (DCF) and Residual Income (Ri)

Fulbright Economics Teaching Program

18 Pages Posted: 17 Mar 2001

See all articles by Joseph Tham

Joseph Tham

Educational Independent Consultant

Date Written: February 2001

Abstract

Recently, the residual income (RI) model has become very popular in valuation because it purports to measure "value added" by explicitly taking into account the cost for capital in the income statement. Some proponents of the residual income approach have even suggested that the RI model is superior to the discounted cash flow (DCF) method and consequently, the DCF model should be abandoned in favor of the RI model. The residual income model is seductive because it purports to provide assessments of performance at any given point in time. The claim that the RI model is superior to the DCF model in valuation is puzzling because the RI model is simply an interesting algebraic rearrangement of the DCF model. Since the same information is used in both models, it is not unexpected that both models should give the same valuation results.

In this paper, I examine the idea that the residual income model is superior to the discounted cash flow model. Using a simple numerical example, I show that in a M & M world, the two approaches to valuation are equivalent. In practice, the choice between the two valuation methods will be determined by the ease with which the relevant information is available.

Keywords: Economic Value Added, Residual Income Model, Free Cash Flow

JEL Classification: D61, G31, H43, M41

Suggested Citation

Tham, Joseph, Equivalence between Discounted Cash Flow (DCF) and Residual Income (Ri) (February 2001). Fulbright Economics Teaching Program, Available at SSRN: https://ssrn.com/abstract=261126 or http://dx.doi.org/10.2139/ssrn.261126

Joseph Tham (Contact Author)

Educational Independent Consultant ( email )

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