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101 Concepts for the Level I Exam

Essential Concept 59: Strengths and Weaknesses of Residual Income Models


Strengths of the residual income model include:

  • The model gives less weight to terminal value.
  • RI models use readily available accounting data.
  • It can be used to value non-dividend paying companies.
  • It can be used to value companies with no positive expected near-term free cash flows.
  • It can be used when cash flows are unpredictable.

Weaknesses of the residual income model include:

  • The model is based on accounting data that is prone to manipulation.
  • The accounting data may need adjustments.
  • The model assumes that the clean surplus relation holds good.
  • The model assumes that the cost of debt is equal to the interest expense.

Residual income models are most appropriate when:

  • A company does not pay dividends.
  • A company’s expected free cash flows are negative.
  • When there is uncertainty in forecasting terminal values.

Residual income models are not appropriate when:

  • The clean surplus relationship does not hold.
  • The determinants of residual income such as book value and ROE are not predictable.