Strengths and Weaknesses of the Residual Income Model

Strengths

• The terminal value does not make up a large portion of the total present value relative to other models.
• Residual income models use readily available accounting data.
• Residual income models can be applied to companies that do not pay dividends or do not have positive free cash flows.
• The models can be used when cash flows are not predictable.
• The models focus on economic profitability.

Weaknesses

• The accounting data that the model is based on is subject to manipulation.
• The accounting data used may require adjustments.
• The model requires that the clean surplus holds. To calculate clean surplus earnings, all components that affect the book value of equity should be incorporated in earnings and flow to the income statement. If this does not hold, adjustments need to be made.
• The residual income model assumes that the cost of debt capital is appropriately reflected by interest expense.

The residual income model is appropriate when:

• A firm does not pay dividends or pays them in an unpredictable manner.
• The expected free cash flows of a firm are negative.
• There is a significant degree of uncertainty in forecasting terminal values.

The residual income model is least appropriate when:

• Clean surplus accounting does not hold.
• Determinants of residual income like book value and ROE are not predictable.

The residual income model, just like the discounted dividend and free cash flow models, can also be used to compute justified market multiples, such as the price-to-earnings ratio (P/E) or price-to-book ratio (P/B).

The residual income model can also be used together with other models to evaluate the consistency of results. If a wide variation of computed value is observed and each model appears appropriate, the inconsistency may be due to the assumptions used in the models.

Question

The residual income approach is most appropriate when:

1. determinants of residual income like book value and ROE are not predictable.
2. there is a significant degree of doubt in forecasting terminal values.
3. clean surplus accounting holds.

Solution

The correct answer is B. 

When there is a significant degree of doubt in forecasting terminal values, it would be most appropriate to use the residual income approach because the terminal value does not constitute a large portion of the intrinsic value.

A is incorrect. When determinants of residual income like book value and ROE are not predictable, the residual income approach would not be appropriate because these two are significant components of the residual income model.

C is incorrect. The residual income approach is appropriate when clean surplus holds, i.e., when all items that affect the book value of equity are included in earnings and flow in the income statement. If this is not the case, an analyst would be required to adjust or use a different valuation model of adjustments if they cannot adjust.

Reading 26: Residual Income Valuation

LOS 26 (j) Explain strengths and weaknesses of residual income models and justify the selection of a residual income model to value a company’s common stock.