CFAI book P68 says that FCFE is related to the claims valuation approach. Similarly, is FCFE also related to the residual income approach, because they are both from the shareholder’s standpoint and both use cost of equity as the discount rate?
FCFE is what is left to Equity Holders after paying all debt holders. Residual Income is what is left after paying Debt holders as well as Equity Holders. Residual Income approach is based on Economic Value of the Firm and FCFE is based on Value for Shareholders. For valuation you need to estimate 2 components; cashflows and discount rate, right? Well, in both these methods, discount rate may be same but cashflows are different. But, Valuation if done correctly under both methods should come out to be the same. So, based on the circumstances and availability of data, you will choose which method to go for. Usually data for Residual Income approach is readily available from accounting books, so this method could be preferred when FCFE cannot be forecasted correctly due to volatility or it being negative in forecasted years. But when there are questions on Earning Quality reported in Accounting Books, Residual Income approach may not be appropriate without having to do lot of adjustments. FCFE being a cash based figure as against accural based NI (used in Residual approach) could be preferred. Does it answer your question?
Yes, thank you rus1bus!