Equivalence between Discounted Cash Flow (DCF) and Residual Income (RI) (Su Tuong Duong Giua Dong Tien Chiet khau va Thu Nhap Rong)

Financial Project Appraisals Working Paper No. 001-2003

20 Pages Posted: 5 May 2003  

Joseph Tham

Duke University - Duke Center for International Development in the Sanford School of Public Policy

Tran Viet Thang

affiliation not provided to SSRN

Date Written: February 2003

Abstract

Recently, the residual income (RI) model has become very popular in valuation because it purports to measure "value added" by explicitly taking into account the cost for capital in the income statement. Some proponents of the residual income approach have even suggested that the RI model is superior to the discount cash flow (DCF) method and consequently, the DCF model should be abandoned in favor of the RI model. The residual income model is seductive because it purports to provide assessments of performance at any given point in time. The claim that the RI model is superior to the DCF model in valuation is puzzling because the RI model is simply an interesting algebraic rearrangement of the DCF model. Since the same information is used in both models, it is not unexpected that both models should give the same valuation results.

In this paper, I examine the idea that the residual income model is superior to the discounted cash flow model. Using a simple numerical example, I show that in a M & M world, the two approaches to valuation are equivalent. In practice, the choice between the two valuation methods will be determined by the ease with which the relevant information is available.

Notes: The downloadable paper is in Vietnamese.

Keywords: Economic Value Added, Residual Income Model, Cash Flow Model

JEL Classification: D61, G31, H43

Suggested Citation

Tham, Joseph and Thang, Tran Viet, Equivalence between Discounted Cash Flow (DCF) and Residual Income (RI) (Su Tuong Duong Giua Dong Tien Chiet khau va Thu Nhap Rong) (February 2003). Financial Project Appraisals Working Paper No. 001-2003. Available at SSRN: https://ssrn.com/abstract=381880 or http://dx.doi.org/10.2139/ssrn.381880

Joseph Tham

Duke University - Duke Center for International Development in the Sanford School of Public Policy ( email )

Box 90312
302, Towerview Dr, Rubenstein Hall, Room 272
Durham, NC 27708
United States
919-613-9234 (Phone)
919-681-0831 (Fax)

HOME PAGE: http://fds.duke.edu/db/Sanford/faculty/thamjx

Tran Viet Thang (Contact Author)

affiliation not provided to SSRN

Paper statistics

Downloads
1,171
Rank
13,200
Abstract Views
8,224