Firm valuation: comparing the residual income and discounted cash flow approaches

Abstract

This study compares the discounted cash flow approach and an accrual based valuation approach: the residual income model. Given the theoretical equivalence between the residual income and discounted cash flow approaches this, study examines whether it is possible to infer a valuation approach that is superior to the other from a user perspective. The two valuation approaches are compared on the basis of analytical attractiveness. This study demonstrates that if practitioners introduce simplifying assumptions in their firm valuation, they also introduce biases in their firm value estimates. In some cases the residual income approach yields more accurate firm value estimates, while in others the discounted cash flow approach yields more accurate estimates. Further, the impact of simplifying assumptions on firm value estimates can be significant. Thus, it is important that practitioners introducing simplifying assumptions are aware of the impact on firm value estimates. Finally, since the framework for forecasting is often based on accrual accounting and the budget control is generally based on accounting numbers rather than cash flow numbers, it seems logical to estimate firm values based on concepts known from accrual accounting and financial statement analysis, i.e. the residual income approach.