Academic journal article Accounting & Taxation

Residual Income versus Discounted Cash Flow Valuation Models: An Empirical Study

Academic journal article Accounting & Taxation

Residual Income versus Discounted Cash Flow Valuation Models: An Empirical Study

Article excerpt


Valuation plays a central role in the financing, investing and operating decisions of companies and many methods are employed to approximate the true value of a company. Although these techniques are based on similar theory, they may generate different results in application. This study incorporates an empirical approach to compare the outcomes of two different methods: residual income and discounted cash flow valuation models. The aim of this study is to test whether these methods result in different values and to contribute to the understanding of why these two valuation techniques, although similar in theory, may generate different results when applied to real life companies. There are a number of studies that compare these two methods theoretically. Some studies claim the superiority of one method over the other and some argue that these two methods should yield the same results when applied properly. In this study, the residual income and discounted cash flow models are applied to nine Turkish companies and the results are compared. We have obtained the data for the study with site visits to the companies and with the help of the managements of the companies.

JEL: G32

KEYWORDS: Valuation, Residual Income Model, Discounted Cash Flow Model, Accounting Based Valuation, Case Study, Turkey


Valuation has been an important topic of finance research for a long time. The estimation of the true value of a business firm challenged academicians as well as practitioners, company owners, managers, and consulting firms in the past and it will most likely continue be a challenging issue in the future. Companies need their equities valued for various reasons such as borrowing, initial public offering, and merging or being acquired. Valuation is of growing importance especially in emerging countries, such as Turkey, which is a country with a growing economy and with a lot of attraction for foreign investments.

The valuation models can be classified into three categories, which can be associated with the income, market, and cost approaches, respectively: discounted cash flow valuation, relative valuation, and contingent claim valuation. There is also a fourth category usually added to these three categories, accounting based valuation (Bertoncel, 2006). Each approach embodies different models and these models often produce significantly different values (Damodaran, 2002). The most widely used model among these is the discounted cash flow valuation model.

The aim of the discounted cash flow models is to approximate intrinsic value and the main principle of the models is to find the present value of the future expected cash flows on an asset. To find the present value of an asset the models require the knowledge of the life of the asset, expected annual cash flows over the life of the asset, and an appropriate discount rate as inputs. Based on empirical evidence, these models can be found to work best when the cash flows produced by an asset is positive (Damodaran, 2002). Relative valuation depends on finding similar assets that are priced in a market, determining a standardized price through multiples, and controlling for the differences between the asset being valued and the similar assets (Damodaran, 2005). Contingent claim valuation is based on option pricing, which regards the asset subject to valuation as a real option and uses option pricing techniques to find the value of it. This model is found to be most useful for the companies in trouble or companies with intensive research and development but with no cash inflows. Accounting based valuation focuses on asset based valuation, and the emphasis is on book value (Damodaran, 2005).

The two methods that are compared in this study are the discounted cash flow valuation model and the residual income model, which is a model of a hybrid approach including insights from both the income approach and the cost approach. The residual income model includes in the value of a company not only the discounted future abnormal earnings but also the book value of the company as of the valuation day. …

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