Hi, I’m a little bit confused when I was studying dividend discount model and residual income model. These two ways of valuation should lead to the same intrinsic value of the same stock. In residual income model, intrinsic value= current book value+ present value of future residual income. However, in dividend discount model, intrinsic value= present value of future dividends. Why do we not add current book value in dividend discount model? In my way of thinking, dividend discount model only measures future profitability of the stock, without accounting for the ownership value of the firm. Is the stock valuation based on DDM baised?
In both systems you are valuing the stock value (equity), no the firm value.
In the residual income model, we use a base value + upside. In DDM, we use cash flow. Both models should reflect the same stock values if applied correctly. Check the assumptions behind the correct usage of each model.
DDM does not need any other adjustments.
I will like to clarify the points based on my understanding.
DDM is not biased, it’s perfectly designed.
Let’s say you buy an equity share Today. After you have bought it, will you receive past dividends ? No Right. The only cash flow you will receive will be all future dividends.
So the value of the equity share today must be equal to the present value of all future dividends. That’s what DDM does. So DDM is discounting total return of equity.
Residual Income approach is based on different logic.
Residual income = Net Income - Equity Charge.
Now Equity charge indicates a total expected return for equity shareholders which should ideally include both dividend and growth component.
So Residual Income is… what is left for equity shareholders after paying their expected return (Equity charge). So something which is extra over and above expected equity charge.
For valuation of equity you should discount total return of equity and not just the extra part.
Hence, for residual income approach you use “Current Book Value + PV of future residual income”