Strengths/Weaknesses

DDM and FCFE models measure value by discounting a stream of expected cash flows. The residual income model starts with a book value and adds to this the present value of the expected stream of residual income. Theoretically, the intrinsic value derived using expected dividends, expected free cash flow to equity, or book value plus expected residual income should be identical if the underlying assumptions used to make the necessary forecasts are the same.

In reality, however, it is rarely possible to forecast all of the common inputs with the same degree of accuracy, and the different models yield different results. It may be helpful though, to use a residual income model alongside a DDM or FCFE model to assess the consistency of results. If the different models provide dramatically different estimates, the inconsistencies may result from the models’ underlying assumptions.

Strengths of residual income models include the following:

• Terminal value does not dominate the intrinsic value estimate, as is the case with dividend discount and free cash flow valuation models.
• Residual income models use accounting data, which is usually easy to find.
• The models are applicable to firms that do not pay dividends or that do not have positive expected free cash flows in the short run.
• The models are applicable even when cash flows are volatile.
• The models focus on economic profitability rather than just on accounting profitability.

Weaknesses of residual income models include the following:

• The models rely on accounting data that can be manipulated by management.
• Reliance on accounting data requires numerous and significant adjustments.
• The models assume that the clean surplus relation holds or that its failure to hold has been properly taken into account.

Residual income models are appropriate under the following circumstances:

• A firm does not pay dividends, or the stream of payments is too volatile to be sufficiently predictable.
• Expected free cash flows are negative for the foreseeable future.
• The terminal value forecast is highly uncertain, which makes dividend discount or free cash flow models less useful.

Residual income models are not appropriate under the following circumstances:

• The clean surplus accounting relation is violated significantly.
• There is significant uncertainty concerning the estimates of book value and return on equity.

Conceptually, the residual income model is very straightforward; we just forecast residual income using some easily available accounting numbers and estimate the value of the equity. Unfortunately, in practice it’s not quite so simple because we have to make a lot of adjustments to reported net income to arrive at a true measure of comprehensive income, which is an income measure that includes all the firm’s valuation changes. Following is a discussion of some common accounting issues that come up when we try to apply residual income models.

Clean Surplus Violations

The clean surplus relationship (i.e., ending book value = beginning book value + net income − dividends) may not hold when items are charged directly to shareholders’ equity and do not go through the income statement. Therefore, we have to adjust net income to account for these items if they are not expected to reverse in the future. Items that can bypass the income statement include:

• Foreign currency translation gains and losses that flow directly to retained earnings under the current rate method.
• Certain pension adjustments.
• Gains/losses on certain hedging instruments.
• Changes in revaluation surplus (IFRS only) for long lived assets.
• Changes in the value of certain liabilities due to changes in the liability’s credit risk (IFRS only).
• Changes in the market value of debt and equity securities classified as available for- sale.

The effect of violations of the clean surplus relationship is that net income is not correct, but book value is still correct. The risk in applying the residual income model when the clean surplus relation doesn’t hold is that the ROE forecast will not be accurate if the clean surplus violations are not expected to offset in future years. For example, suppose the analyst determines that the clean surplus relation is violated because of the cumulative translation adjustment (CTA) resulting from the application of the current rate method of currency translation.

(See the reading on Multinational Operations if the current rate method doesn’t sound familiar!) If the CTA tends to reverse over time and is not consistently positive or negative, the ROE can be forecasted without taking into account the CTA.

Variations from Fair Value

The accrual method of accounting causes many balance sheet items to be reported at book values that are significantly different than their market values. Common adjustments to the balance sheet necessary to reflect fair value include the following:

• Operating leases should be capitalized by increasing assets and liabilities by the present value of the expected future operating lease payments. Interest expense in the income statement should be close to the true cost of debt.
• Special purpose entities (SPEs) whose assets and liabilities are not reflected in the financial statements of the parent company should be consolidated.
• Reserves and allowances should be adjusted. For example, the allowance for bad debts, which is an offset to accounts receivable, should reflect the expected loss experience.
• Inventory for companies that use LIFO (last in, first out) should be adjusted to FIFO (first in, first out) by adding the LIFO reserve to inventory and equity, assuming no deferred tax impact.
• The pension asset or liability should be adjusted to reflect the funded status of the plan, which is equal to the difference between the fair value of the plan assets and the projected benefit obligation (PBO).
• Deferred tax liabilities should be eliminated and reported as equity if the liability is not expected to reverse (e.g., if the deferred tax liability results from different depreciation methods for tax and financial statement reporting purposes, and if the company is growing).

Intangible Asset Effects on Book Value

Two intangible assets require special attention: (1) intangibles recognized at acquisition and (2) R&D expenditures.

Recognition of an identifiable intangible asset (such as a license) in the group accounts that was not previously recorded in the investee company balance sheet creates a distortion in valuation under a residual income model. The amortization of such intangible assets reduces the combined ROE, and hence results in lower valuation of the combined entity compared to the sum of the values of individual entities prior to acquisition. To remove this distortion, the amortization of intangibles capitalized during acquisition should be removed prior to computing the ROE used for residual income valuation.

The suggested analytical treatment of R&D expenditures is less definitive, but we can make the general statement that the ROE estimate for a mature company should reflect the long term productivity of the company’s R&D expenditures: Productive R&D expenditures increase ROE and residual income, and unproductive expenditures reduce ROE and residual income.

Nonrecurring Items and Other Aggressive Accounting Practices

Nonrecurring items should not be included in residual income forecasts because they represent items that are not expected to continue in the future. Items that may need adjustment in measuring recurring earnings include discontinued operations, accounting changes, unusual items, extraordinary items, and restructuring charges.

Firms may adopt other types of aggressive accounting practices that overstate the book value of assets and earnings by, for example, accelerating revenues to the current period or deferring expenses to a later period.

International Accounting Differences

Residual income models, which are based on accrual accounting information, may not be as useful in valuing foreign firms because of differences in national accounting standards. Some things to consider in applying residual income models in global valuation settings include the following:

• How reliable are earnings forecasts?
• Are there systematic violations of the clean surplus relation?
• Do poor quality accounting rules result in financial statements that bear no resemblance to the economic reality of the business?

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