Residual Income Valuation Model:
According to Ohlson’s fundamental model the appropriate Equity Value is the result of the
book value of firm and the future excess equity returns generated. This computation of residual
income valuation model that is derived from the DDM is as follows (Damodaran,2006):
Inserting the given values into the equation, the BV of equity as a function of the starting
book equity, dividends and earnings over a period of time also known as Clean Surplus
Relationship (Damodaran,2006)
Book Value of Equity t = BV of Equity t - 1 + Net Income t – Dividends t
Incorporating the same in dividend discount model, it results in:
Hence, company value is the summation of it’s Book Value of Equity and the PV of the
expected excess returns to equity shareholders in perpetuity. (Damodaran,2006)
Limitations and Attractiveness of the RI model:
As the Ohlson model does not provide any ground-breaking insights, accounting researches
receiving it with this fervour is a bit confusing. The development of the DDM was by Walter
(1966) and Mao (1974) in order to account for excess returns on any investments in the future.
(Damodaran,2006)
The RI model is based on the assumption the clean surplus relationship is valid only if equity
stock is not adjusted and all income reflects in the income statement. RI can only be
determined if the clean surplus relationship is valid. If the relationship isn't consistent, basic
assumptions might be used to determine RI. Researches state that firm value estimated can be
prejudiced if we use simplifying assumptions (for instance, growth, WACC computed using
long term capital structure) (Negakis,2005).
Theoretically, the Clean surplus model is under the assumption that the accounting of dirty
surplus net income items and other comprehensive income items has been carried out
accurately to generate firm’s value. In order to determine unbiased firm value, the assumption
made has to be unbiased. Additionally, RI based risk measure could be biased as they rely on
accounting information reflected in ne earnings and book value. For instance, RI models are
influenced by both conservative and liberal accounting. (Plenborg 2002) states that when
liberal accounting is used high ROE is generated in the year of expenditure. However, it
gradually decreases in the years to follow.
(Nergakis 2005) states .. to be written
Another negative implication if the RI model is that it doesn’t take into consideration the
economical risk fluctuations and believes in uniformity. In other words, a stagnant cost of
capital suggesting that the RI model is simply a constant (In this case, cost of equity)
subtracted from the ROE. Contrary to the DCF model, the RI model focuses on the book
value of the firm, hence the firm’s value will not be impacted by the changes in the growth
rate (Plenborg, 2002). In the DCF Approach, if the growth rate is lesser/greater than
forecasted financial statements, it would lead to undervaluation/ overvaluation of the firm.
Additionally, since the RI model uses the information that is already established by the firm
in their financial statements i.e Book value, it is comparatively less sensitive than the DCF
approach.
The DDM and the DCF approaches are the distributors of value measures. On the other hand,
The RI model is a value creation measure. Comparatively, valuation creation models are
simpler to clarify and interpret than the distribution of value measures. Cash flows can be
subjective in nature (Plenborg, 2002). A positive RI indicates that the company’s price to
book value should be greater than one, On the contrary, a positive cashflow does not indicate
the same. Arguably, this indicates that the firm valued using the RI model is easier to
understand and explain that the firm valued using free cash-flows. Additionally, the RI model
doesn't react to the various accounting methods the company uses for determining book
values and earnings, provided that the clean surplus accounting is used in the projected
financial statements (Ohlson, 1995). Therefore, the NPV maximization rule in making
investment decisions coupled with these reasons makes the RI Model analytically appealing.