Reconciling Value Estimates from the Discounted Cash Flow Model and the Residual Income Model

Posted: 17 Apr 2001

See all articles by Russell J. Lundholm

Russell J. Lundholm

University of British Columbia - Sauder School of Business

Terry O'Keefe

University of Queensland - Accounting and Accountability; University of Oregon - Department of Accounting

Abstract

This paper examines why practitioners and researchers get different estimates of equity value when they use a discounted cash flow (CF) model versus a residual income (RI) model. Both models are derived from the same underlying assumption - that price is the present value of expected future net dividends discounted at the cost of equity capital - but in practice and in research they frequently yield different estimates. We argue that the research literature devoted to comparing the accuracy of these two models is misguided; properly implemented, both models yield identical valuations for all firms in all years. We identify how prior research has applied inconsistent assumptions to the two models and show how these seemingly small errors cause surprisingly large differences in the value estimates.

Keywords: Valuation; Residual income; Discounted cash flow

JEL Classification: D46, G12, M40, M41

Suggested Citation

Lundholm, Russell J. and O'Keefe, Terry, Reconciling Value Estimates from the Discounted Cash Flow Model and the Residual Income Model. Available at SSRN: https://ssrn.com/abstract=265752

Russell J. Lundholm (Contact Author)

University of British Columbia - Sauder School of Business ( email )

2053 Main Hall
Vancouver, British Columbia V6T 1Z2
Canada

Terry O'Keefe

University of Queensland - Accounting and Accountability ( email )

Brisbane 4072, Queensland
Australia

University of Oregon - Department of Accounting ( email )

Lundquist College of Business
1208 University of Oregon
Eugene, OR 97403
United States

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