Cash flow
Article 1discusses how different estimates of equity value are obtained by researchers while using the discounted cash flow model (CF) and the Residual income (RI) model. It recognises the inconsistencies prevalent while implementing them. Francis et al (2000) use Value line estimates for finite forecasting periods. They conclude that RI is superior to CF. Courteau et al (2000) analyse whether different valuation models are same when a terminal value calculation based on price is used. They conclude that RI is dominant to CF when terminal price forecasts are not obtainable. Penman and Sougiannis (1998) examine the differences in model estimates by using a portfolio of ex post realizations of financial statement data. They conclude that methods based on projecting GAAP accrual earnings give lower valuation errors than forecasting cash flows.
The inconsistent forecasts error occurs when there is an error in the starting value of the terminal value perpetuity. In order to prevent this error, a financial statement forecast in the terminal period using the terminal growth rate has to be developed and the relevant valuation attribute in the year T + 1 should be constructed. This error is experienced in all three papers. The inconsistent discount rate error arises due to inconsistency between cost of equity capital and weighted average cost of capital. This error is experienced by Francis and Penman. The missing cash flow error exists due to an inconsistent way of calculating the valuation attributes. Courteau and Francis suffer this error.
Therefore this article argues that RI’s superiority over CF is mistaken and disproves the commonly held notion that practical implementation issues cause differences in the RI and CF models which are equivalent theoretically and empirical comparison is worthwhile. In order to get the same value estimates for each model proper care should be taken while using financial statements
In Article 2, the paper by Lundholm and O’ Keefe
The inconsistent forecasts error occurs when there is an error in the starting value of the terminal value perpetuity. In order to prevent this error, a financial statement forecast in the terminal period using the terminal growth rate has to be developed and the relevant valuation attribute in the year T + 1 should be constructed. This error is experienced in all three papers. The inconsistent discount rate error arises due to inconsistency between cost of equity capital and weighted average cost of capital. This error is experienced by Francis and Penman. The missing cash flow error exists due to an inconsistent way of calculating the valuation attributes. Courteau and Francis suffer this error.
Therefore this article argues that RI’s superiority over CF is mistaken and disproves the commonly held notion that practical implementation issues cause differences in the RI and CF models which are equivalent theoretically and empirical comparison is worthwhile. In order to get the same value estimates for each model proper care should be taken while using financial statements
In Article 2, the paper by Lundholm and O’ Keefe