SSE/EFI Working Paper Series in Business Administration
A Tutorial on Residual Income Valuation and Value Added Valuation
Abstract: Two valuation models based on accounting concepts and
measurements are specified and discussed in the paper - a "residual income
valuation" model and a "value added valuation" model. Given clean surplus
accounting, the first model is identical to a model where future expected
dividends and a horizon value of owners' equity are discounted to a present
value. Similarly, the second model is identical to a free cash flow
valuation framework, as specified in the well-known "McKinsey model"
(Copeland, Koller & Murrin, 1994). The valuation models being specified in
the paper use accounting measures of capital, capital growth and return on
capital to calculate a fundamental value of owners' equity. As a certain
connection between the required market rate of return ("cost of capital"),
the accounting return on capital and capital growth can be expected to hold
in the long run, the valuation models provide for some simplification of
typical prediction problems inherent in fundamental valuation analysis.
Keywords: Conservative accounting; economic value added; financial ratios; fundamental analysis; residual income; valuation; (follow links to similar papers)
25 pages, October 27, 1999, Revised September 3, 2002
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