Reconciling Value Estimates from the Discounted Cash Flow Value Model and the Residual Income Model

Abstract

In this paper we investigate why the discounted cash flow model and residual income model frequently give different value estimates. We identify three common errors in the implementation of the models and show that these errors affect the models in different ways, creating differences in the value estimates that each produces. Our estimates of the size and direction of these errors roughly reconciles the observed differences in value estimates from papers attempting to "horse-race" the models. We also argue that any such contest is ill-conceived; given the same set of forecasted financial statements all models derived from the basic dividend-discounting assumption should yield the same value estimate. We discuss why claims of the residual income model's superiority over the discounted cash flow model, both on empirical and theoretical grounds, are misstated.