The Use of Residual Income Valuation Methods by U.S. Sell-Side Equity Analysts

46 Pages Posted: 21 Jan 2015 Last revised: 25 Aug 2016

See all articles by John R. M. Hand

John R. M. Hand

University of North Carolina Kenan-Flagler Business School

Joshua G. Coyne

University of Memphis - School of Accountancy

Jeremiah Green

Texas A&M University - Department of Accounting

Frank Zhang

Yale School of Management

Date Written: August 24, 2016

Abstract

We study the use of residual income (RI) valuation methods by U.S. sell-side equity analysts, particularly as compared to DCF. We document that RI valuations are rare — just 1/16th as common as DCF — and that different RI and DCF valuations are not infrequently provided by the same analyst for the same firm in the same report. We find that while analysts build their RI models around both net operating income (RNOA-RI) and net income (ROE-RI), analysts’ RNOA-RI valuations are as optimistic as their DCF valuations and contain RNOAs that increase to an economically implausible terminal year median of 27%. In contrast, analysts’ ROE-RI valuations contain ROEs that decline over the forecast horizon to a more plausible terminal year median of 17%. While optimistic when done on their own, analysts’ ROE-RI valuations are unbiased when done in tandem with DCF, as are the DCFs that accompany them.

Keywords: Residual income valuation, DCF, sell-side equity analysts

JEL Classification: G12, G17, G32

Suggested Citation

Hand, John R. M. and Coyne, Joshua G. and Green, Jeremiah and Zhang, Frank, The Use of Residual Income Valuation Methods by U.S. Sell-Side Equity Analysts (August 24, 2016). Available at SSRN: https://ssrn.com/abstract=2552537 or http://dx.doi.org/10.2139/ssrn.2552537

John R. M. Hand (Contact Author)

University of North Carolina Kenan-Flagler Business School ( email )

McColl Building
Chapel Hill, NC 27599-3490
United States
919-962-3173 (Phone)
919-962-4727 (Fax)

Joshua G. Coyne

University of Memphis - School of Accountancy ( email )

Fogelman College of Business and Economics
Memphis, TN 38152-6460
United States

Jeremiah Green

Texas A&M University - Department of Accounting ( email )

430 Wehner
College Station, TX 77843-4353
United States

Frank Zhang

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

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