On Comparing Residual Income and Discounted Cash Flow Models of Equity Valuation

Download or read book On Comparing Residual Income and Discounted Cash Flow Models of Equity Valuation written by Russell J. Lundholm and published by . This book was released on 2001 with total page 6 pages. Available in PDF, EPUB and Kindle. Book excerpt: In the Summer 2001 issue of Contemporary Accounting Research we published a paper arguing that, given a full set of forecasted financial statements, the value estimates from a residual income model and a discounted cash flow model should yield identical results. The reason prior empirical studies (Penman and Sougiannis 1998 and Francis, Olsson and Oswald 2000) found differences between the models is because of subtle errors in the implementation of the models. Penman (2001) understandably takes issue with our paper, claiming that we are wrong on three points. We feel quite confident in our original paper and will rebut each of Penman's claims. Penman repeatedly states that he is interested in practical issues surrounding valuation. We share this interest; in fact, we were motivated to write our paper because of the common question raised by students and faculty: quot;why do I get a different answer from my discounted cash flow valuation than from my residual income valuation?quot; We still maintain that, if carefully done, there will be no difference in the valuations from these theoretically equivalent models. Our paper shows exactly how to do this and illustrates commonly made mistakes.