Residual income valuation

CFA Level II
#1

Finally, I ve reached to mock exams,

I cannot agree with the answer on one of the questions which says:

"The residual income model, also called the excess earnings method, does not have the same weakness as the FCFE approach, because it is an estimate of the profit of the company after deducting the cost of all capital: debt and equity. Further, it makes no assumptions about future earnings and dividend growth" let’s recall the formula of RI valuation: BVo + ((ROE - r)/(r-g))*BVo, So, growth rate in explicilty incorporated in the RI valuation model which contradicts to the statement that no asssumtions about future earnings are required. Would appreciete if you can clarify, where I am wrong?

#2

RIM only says V = BV + sum (t = 1 to infinity) of RI(t)/(1+r)^t. Nothing about g.

A sub-model is when you further assume that the company will reach a terminal growth rate g and terminate the sum early by substituting the terminal value for all further RI(t)/(q+r)^t terms. i.e.

V = BV + sum (t = 1 to N) of RI(t)/(1+r)^t + terminal value after N years based on some computation with r and g.

#3

Thanks Naren,

however, still not clear. even basing on broader formula of V = BV + sum (t = 1 to infinity) of RI(t)/(1+r)^t, you must make an assumtion regarding the second part of equation (sum (t = 1 to infinity) of RI(t)/(1+r)^t) which is assumtion about future earnings, don’t you?

#4

I think they are refering to the excess earning method used to value private equity ( reading 39) not RI model from reading 38