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Three residual income valuation methods and discounted cash flow valuation

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  • Fernandez, Pablo

    (IESE Business School)

Abstract

In this paper we show that the three residual Income models for equity valuation always yield the same value as the Discounted Cash Flow Valuation models. We use three residual income measures: Economic Profit, Economic Value Added (EVA) and Cash Value Added. We also show that economic profit and EVA are different, although Copeland, Koller and Murrin (2000, page 55) say that economic profit is a synonym of EVA. Specifically, we first show that the present value of the Economic Profit discounted at the required return to equity plus the equity book value equals the value of equity. The value of equity is the present value of the Equity cash flow discounted at the required return to equity. Then, we show that the present value of the EVA discounted at the WACC plus the enterprise book value (equity plus debt) is the enterprise market value. The enterprise market value is the present value of the Free cash flow discounted at the WACC. Then, we show that the present value of the Cash Value Added discounted at the WACC plus the enterprise book value (equity plus debt) is the enterprise market value. The enterprise market value is the present value of the Free cash flow discounted at the WACC.

Suggested Citation

  • Fernandez, Pablo, 2003. "Three residual income valuation methods and discounted cash flow valuation," IESE Research Papers D/487, IESE Business School.
    • Handle: RePEc:ebg:iesewp:d-0487
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    File URL: http://www.iese.edu/research/pdfs/DI-0487-E.pdf
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    References listed on IDEAS

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    1. Stephen H. Penman & Theodore Sougiannis, 1998. "A Comparison of Dividend, Cash Flow, and Earnings Approaches to Equity Valuation," Contemporary Accounting Research, John Wiley & Sons, vol. 15(3), pages 343-383, September.
    2. Russell J. Lundholm & Terrence B. O'Keefe, 2001. "On Comparing Residual Income and Discounted Cash Flow Models of Equity Valuation: A Response to Penman 2001 (CAR, Winter 2001)," Contemporary Accounting Research, John Wiley & Sons, vol. 18(4), pages 693-696, December.
    3. Russell Lundholm & Terry O'Keefe, 2001. "Reconciling Value Estimates from the Discounted Cash Flow Model and the Residual Income Model," Contemporary Accounting Research, John Wiley & Sons, vol. 18(2), pages 311-335, June.
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    Cited by:

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    3. Nangia, Vinay Kumar & Agrawal, Rajat & Reddy, K. Srinivasa, 2011. "Business Valuation: Modelling Forecasting Hurdle Rate," MPRA Paper 60420, University Library of Munich, Germany, revised 2011.
    4. Andrzej Jaki & Wojciech Ćwięk, 2020. "Bankruptcy Prediction Models Based on Value Measures," JRFM, MDPI, vol. 14(1), pages 1-14, December.

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    More about this item

    Keywords

    cash value added; EVA; economic profit; residual income valuation; discounted cash flow valuation; valuation;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • M21 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Economics - - - Business Economics

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