On Comparing Residual Income and Discounted Cash Flow Models of Equity Valuation: A Response to Penman 2001 (CAR, Winter 2001)*

Abstract

In the Summer 2001 issue of Contemporary Accounting Research we published a paper arguing that, given a full set of forecasted financial statements, the value estimates from a residual income model and a discounted cash flow model should yield identical results. The reason prior empirical studies (Penman and Sougiannis 1998 and Francis, Olsson, and Oswald 2000) found differences between the models is because of subtle errors in the implementation of the models. Penman (2001) understandably takes issue with our paper, claiming that we are wrong on three points. We feel quite confident in our original paper and will rebut each of Penman’s claims. Penman repeatedly states that he is interested in practical issues surrounding valuation. We share this interest; in fact, we were motivated to write our paper because of the common question raised by students and faculty: “Why do I get a different answer from my discounted cash flow valuation than from my residual income valuation?” We still maintain that, if carefully done, there will be no difference in the valuations from these theoretically equivalent models. Our paper shows exactly how to do this and illustrates commonly made mistakes. Further, any practical attempt to value a firm begins with forecasting future financial statements — earnings and book values at a minimum — and then constructs from these estimates the valuation attributes of interest. All the empirical papers discussed in our original paper started with a complete set of pro forma financial statements. We continue with the maintained assumption that these forecasts are available to both the cash flow and the residual income models. In section 3 of Penman’s paper he gives three criticisms of our claim that cash flow and residual income models should yield the same valuation in all cases. His first criticism is that practical considerations require that forecasts are only made up to a finite horizon, and that this introduces an error in the practical implementation of the theoretical model that is worthy of empirical study. We agree that explicit forecasts for each year can be made only for a finite number of years, but we show in our original paper that this constraint will not create a difference between cash flow and residual income model estimates if treated properly. An inconsistency will arise between the models, and with the forecasted financial