Question

What are the strengths and weaknesses of the residual income model as a method of valuing a firm?

Answer 1

Residual income is the net income minus the oppurtunity cost of the share holders. Using this the valuation of a firm can be done effectively.

Some of the strengths and weakness are given below.

• Strengths of the model:

  • Effect of terminal value assumption is small compared to other models like DCF

  • Model uses available accounting data for measurement as per financial statements

  • Model is effectively for firms paying no dividend and or no near term free cash flow.

  • Can be used for highly volatile cashflows

• Weaknesses of the model

  • Model which is based on accounting data are subjected to tampering

  • Significant adjustments might require for use of accounting data for calculation

  • Clean surplus relation should hold for the accurate representation of the model. Else it is necessary to adjust the values to get the same.