On Comparing Residual Income and Discounted Cash Flow Models of Equity Valuation: A Response to Penman 2001

University of Michigan Business School

6 Pages Posted: 31 Oct 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

Multiple version iconThere are 2 versions of this paper

Date Written: July 25, 2001

Abstract

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: "why do I get a different answer from my discounted cash flow valuation than from my residual income valuation?" 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.

Keywords: Valuation; Residual income; Discounted cash flow

JEL Classification: G12, M41

Suggested Citation

Lundholm, Russell J. and O'Keefe, Terry, On Comparing Residual Income and Discounted Cash Flow Models of Equity Valuation: A Response to Penman 2001 (July 25, 2001). University of Michigan Business School. Available at SSRN: https://ssrn.com/abstract=288959 or http://dx.doi.org/10.2139/ssrn.288959

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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