Residual Income vs. DDM and FCF Models

Unlike the residual income model, the discounted dividend and free cash flow models forecast future cash flows and find the value of a stock by discounting them back to the present by using the required return.

Dividends and free cash flow to equity (FCFE) are discounted at the required rate of return on equity (cost of equity), while the free cash flow to the firm (FCFF) is discounted at the weighted average cost of capital (WACC).

The intrinsic value computed through the dividend discount model, free cash flow models, and residual income model should be the same.

A significant fraction of a stock’s total present value in the discounted dividend and free cash flow models is represented by the present value of the expected terminal value. At the same time, residual income valuations are typically less sensitive to terminal value estimates.

Question

Under the residual income model, which of the following most likely constitutes a large portion of a stock’s present value?

1. Present value of the terminal value.
2. Book value.
3. Present value of the current book value.

Solution

The correct answer is B. 

Under the residual income model, the book value constitutes a large portion of the present value of a stock’s present value, unlike in the DDM and free cash flows models, in which the terminal values make up a significant portion of a stock’s intrinsic value.

A is incorrect. The present value of the terminal value makes up a large portion of the intrinsic value under both DDM and free cash flow models. This intrinsic value is highly sensitive to terminal value estimates.

C is incorrect. The current book value is not discounted when computing a stock’s present value. 

Reading 26: Residual Income Valuation

LOS 26 (i) Compare residual income models to dividend discount and free cash flow models.