Hello, Here is the question from the CFA exercises online- equity part Mendosa case. In regard to the discussion on other approaches between Mendosa and Raman, which of the following statements that they make is most accurate? Statement: 1, or 2 or 3? Ok and please look at the right answer that we are supposed to pick among the 3 choices:
“The residual income (RI) model, also called the “excess earnings method,” does not have the same weakness as the FCFE approach because residual income is an estimate of the profit of the company after deducting the cost of all capital: debt and equity. Furthermore, it makes no assumptions about future earnings and the justified P/B is directly related to expected future residual income.” My concern is here: "** The residual income (RI) model, also called the “excess earnings method,"** The Residual Income model is not called the Excess earnings method (EEM). How are we supposed to pick this statement as correct? The Excess earnings methods is another model. Given this sentence, how can we know that the guys is correctly talking about RI model and not EEM? I dont see why I should have picked this as a correct answer.
Fine… do you have the VitalSource software??? if so, in the search box, type “excess earnings.” If not, read footnote 10 on page 485 of CFAI’s equity book
Think about it… what is residual income? The formula for it is (ROE - r)(Beg Book Value of Equity) where ROE is achieved return on book equity, and r is the investor’s required return on an equity investment.
Hence, ROE - r = excess return over what was required.
Ah right I was suppose to refer to the footnote on page 485…you kidding me? Plus, in the statement, he is not saying that is is called EEM in Tax valuation. (the only time this is also called EEM). He does not make the distinction so I must assume he is talking about the other EEM. You must admit that it’s a little ridiculous.
While I agree that knowing alternative names from a footnote is quite ridiculous, and so is the question they ask, whether the alternative names come from general valuation, tax court, bankruptcy court, investment banking, etc… they’re alternative names nonetheless. Therefore, it would not be incorrect to say the residual income model, also known as the “insert alternative name here” regardless. Because, in fact, in other parts of the world, the residual income model is known as the “insert alternative name here”.
