relevance of residual income model

CFA Level II
#1

A minority share holder would use the DDM to value his shares. A majority shareholder would discount cash flows to value his shares. Who is the residual income model relevant to?

#2

NO ONE…it stinks. Use RI if FCF is negative for the foreseeable future or when cash flows are volitile…or if you want to get laughed at in meetings.

#3

they mention in the books that it isnt used very often, hence I hope there won´t be a question on it because it is time consuming and annoying…so if FCFF I suppose. All firms should pay dividends. Yeah!

#4

If they are gonna ask RI, it’ll most likely be like a one-stage RI to test that you remember adding the BV or more concept related questions.

#5

june2009 Wrote: ------------------------------------------------------- > NO ONE…it stinks. > > Use RI if FCF is negative for the foreseeable > future or when cash flows are volitile…or if you > want to get laughed at in meetings. That’s funny, because from what I’ve heard, Goldman Sachs employs the Residual Income approach quite regularly.

#6

i think the text also mentioned to use it when dividends are not paid and also used to measure goodwill (excess over book value)…

#7

Am i correct in saying that the residual income model PUNISHES companies that pay dividends? Paying dividends reduces book value value per share

#8

Possibly. But, a company that has a stable dividend policy likely has a required return on equity that is less than a non-dividend paying company. So, the equity charge would be less. It all depends…

#9

know that RI models assume “clean surplus relation” - from curriculum: "any acctg charges taken directly to equity accounts will cause clean surplus relation not to hold. Example: AFS securities. RI model valuations recognize value earlier than DDM & FCF. DDM & FCF rely largely on terminal values which are highly uncertain (far in the future). RI model’s inclusion of the known current value (book value) reduces forecast error. Use RI models when: - firms doesn’t pay dividends -OR- dividend stream is too volatile - expected FCF is negative - terminal value forecast is highly uncertain.