Accepted by Jerry Feltham. We thank Jim Ohlson for suggesting a more forceful way to make our point in this paper. We also thank Richard Brief, George Racette, Doug Skinner, Richard Sloan, Joseph Tham, and the workshop participants at Syracuse University and at the 2000 Contemporary Accounting Research Conference for helpful comments. We also thank Arthur Andersen and Ehrman V. Giustina for financial support.
Reconciling Value Estimates from the Discounted Cash Flow Model and the Residual Income Model*
Article first published online: 15 JAN 2010
2001 Canadian Academic Accounting Association
Contemporary Accounting Research
Volume 18, Issue 2, pages 311–335, Summer 2001
How to Cite
Lundholm, R. and O'Keefe, T. (2001), Reconciling Value Estimates from the Discounted Cash Flow Model and the Residual Income Model. Contemporary Accounting Research, 18: 311–335. doi: 10.1506/W13B-K4BT-455N-TTR2
- Issue published online: 15 JAN 2010
- Article first published online: 15 JAN 2010
- Keywords Discounted cash flow;
- Residual income;
This paper examines why practitioners and researchers get different estimates of equity value when they use a discounted cash flow (CF) model versus a residual income (RI) model. Both models are derived from the same underlying assumption — that price is the present value of expected future net dividends discounted at the cost of equity capital — but in practice and in research they frequently yield different estimates. We argue that the research literature devoted to comparing the accuracy of these two models is misguided; properly implemented, both models yield identical valuations for all firms in all years. We identify how prior research has applied inconsistent assumptions to the two models and show how these seemingly small errors cause surprisingly large differences in the value estimates.