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.