The Use of Residual Income Valuation Methods by U.S. Sell-Side Equity Analysts

Abstract

ABSTRACTWe investigate the use and performance of residual income (RI) valuation methods by U.S. sell-side equity analysts in a small-sample manner wherein we extract the rich details of analysts' RI valuations from their PDF reports over the period 1998–2013. We observe that RI valuations are much rarer than discounted cash flow (DCF) valuations, and that different RI and DCF valuations are sometimes provided by the same analyst for the same firm in the same report. We find that while some analysts build RI models around net operating income (RNOA-RI) and others around net income (ROE-RI), RNOA-RI valuations are optimistic to the same degree as DCF valuations and contain RNOAs that increase to an economically unlikely terminal year median of 27 percent. In contrast, analysts' ROE-RI valuations are unbiased when done in tandem with a DCF valuation, as are the DCFs that accompany them, and contain ROEs that decline over the forecast horizon to a more plausible terminal year median of 17 percent. We conclude that analysts' use of ROE-RI methods can lead to more sophisticated forecasts of economic fundamentals and equity valuations, especially when used in tandem with DCF.JEL Classifications: G12; G17; G32.