{"id":21110,"date":"2021-09-08T05:07:15","date_gmt":"2021-09-08T05:07:15","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=21110"},"modified":"2026-03-02T10:43:25","modified_gmt":"2026-03-02T10:43:25","slug":"residual-income-vs-ddm-and-fcf-models","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/residual-income-vs-ddm-and-fcf-models\/","title":{"rendered":"Residual Income vs. DDM and FCF Models"},"content":{"rendered":"<script type=\"application\/ld+json\">\r\n{\r\n  \"@context\": \"https:\/\/schema.org\",\r\n  \"@type\": \"QAPage\",\r\n  \"mainEntity\": {\r\n    \"@type\": \"Question\",\r\n    \"name\": \"Under the residual income model, what typically makes up a large portion of a stock\u2019s present value?\",\r\n    \"text\": \"Under the residual income model, which of the following most likely constitutes a large portion of a stock\u2019s present value?\\n\\nA. Present value of the terminal value.\\n\\nB. Book value.\\n\\nC. Present value of the current book value.\",\r\n    \"answerCount\": 1,\r\n    \"acceptedAnswer\": {\r\n      \"@type\": \"Answer\",\r\n      \"text\": \"The correct answer is B. Under the residual income model, the book value of equity typically represents a large portion of a stock\u2019s intrinsic value. This contrasts with dividend discount and free cash flow models, where a significant portion of value often comes from the present value of terminal value estimates. The current book value itself is not discounted.\"\r\n    }\r\n  }\r\n}\r\n<\/script>\r\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/PBa-kWaY4gs\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><span data-mce-type=\"bookmark\" style=\"display: inline-block; width: 0px; overflow: hidden; line-height: 0;\" class=\"mce_SELRES_start\">\ufeff<\/span><span data-mce-type=\"bookmark\" style=\"display: inline-block; width: 0px; overflow: hidden; line-height: 0;\" class=\"mce_SELRES_start\">\ufeff<\/span><\/iframe><\/p>\r\n\r\n<p>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.<\/p>\r\n<p>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).<\/p>\r\n<p>The intrinsic value computed through the dividend discount model, free cash flow models, and residual income model should be the same.<\/p>\r\n<p>A significant fraction of a stock\u2019s 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.<\/p>\r\n<blockquote>\r\n<h2>Question<\/h2>\r\n<p>Under the residual income model, which of the following most likely constitutes a large portion of a stock\u2019s present value?<\/p>\r\n<ol style=\"list-style-type: upper-alpha;\">\r\n\t<li>Present value of the terminal value.<\/li>\r\n\t<li>Book value.<\/li>\r\n\t<li>Present value of the current book value.<\/li>\r\n<\/ol>\r\n<h3>Solution<\/h3>\r\n<p><strong>The correct answer is B.\u00a0<\/strong><\/p>\r\n<p>Under the residual income model, the book value constitutes a large portion of the present value of a stock\u2019s present value, unlike in the DDM and free cash flows models, in which the terminal values make up a significant portion of a stock\u2019s intrinsic value.<\/p>\r\n<p><strong>A is incorrect. <\/strong>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.<\/p>\r\n<p><strong>C is incorrect. <\/strong>The current book value is not discounted when computing a stock\u2019s present value.\u00a0<\/p>\r\n<\/blockquote>\r\n<p>Reading 26: Residual Income Valuation<\/p>\r\n<p><em>LOS 26 (i) Compare residual income models to dividend discount and free cash flow models.<\/em><\/p>\r\n","protected":false},"excerpt":{"rendered":"<p>\ufeff\ufeff 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&#8230;<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,401],"tags":[216,402,492,499],"class_list":["post-21110","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-equity-valuation","tag-cfa-level-2","tag-equity-valuation","tag-reading-30-residual-income-valuation","tag-residual-income-vs-ddm-and-fcf-models","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.4 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Residual Income vs DDM &amp; FCF | CFA L2<\/title>\n<meta name=\"description\" content=\"Compare the residual income model with DDM and FCF valuation models, including terminal value, assumptions, and sensitivity analysis in CFA Level 2.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/residual-income-vs-ddm-and-fcf-models\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Residual Income vs DDM &amp; FCF | CFA L2\" \/>\n<meta property=\"og:description\" content=\"Compare the residual income model with DDM and FCF valuation models, including terminal value, assumptions, and sensitivity analysis in CFA Level 2.\" \/>\n<meta property=\"og:url\" content=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/residual-income-vs-ddm-and-fcf-models\/\" \/>\n<meta property=\"og:site_name\" content=\"CFA, FRM, and Actuarial Exams Study Notes\" \/>\n<meta property=\"article:published_time\" content=\"2021-09-08T05:07:15+00:00\" \/>\n<meta property=\"article:modified_time\" content=\"2026-03-02T10:43:25+00:00\" \/>\n<meta name=\"author\" content=\"Irene R\" \/>\n<meta name=\"twitter:card\" content=\"summary_large_image\" \/>\n<meta name=\"twitter:label1\" content=\"Written by\" \/>\n\t<meta name=\"twitter:data1\" content=\"Irene R\" \/>\n\t<meta name=\"twitter:label2\" content=\"Est. reading time\" \/>\n\t<meta name=\"twitter:data2\" content=\"1 minute\" \/>\n<script type=\"application\/ld+json\" class=\"yoast-schema-graph\">{\"@context\":\"https:\\\/\\\/schema.org\",\"@graph\":[{\"@type\":\"Article\",\"@id\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/cfa-level-2\\\/residual-income-vs-ddm-and-fcf-models\\\/#article\",\"isPartOf\":{\"@id\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/cfa-level-2\\\/residual-income-vs-ddm-and-fcf-models\\\/\"},\"author\":{\"name\":\"Irene R\",\"@id\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/#\\\/schema\\\/person\\\/7002f30d8f174958802c1c30b167eaf5\"},\"headline\":\"Residual Income vs. DDM and FCF Models\",\"datePublished\":\"2021-09-08T05:07:15+00:00\",\"dateModified\":\"2026-03-02T10:43:25+00:00\",\"mainEntityOfPage\":{\"@id\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/cfa-level-2\\\/residual-income-vs-ddm-and-fcf-models\\\/\"},\"wordCount\":311,\"keywords\":[\"CFA-level-2\",\"Equity Valuation\",\"Reading 30: Residual Income Valuation\",\"Residual Income Vs. 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