Financial Statement Analysis T3 2015/2016

Mathematical Equivalence of Valuation Models

A. Equivalence of Dividend Discount Model (DDM) and Residual
Income Model (RIM)
DDM:

0 =
=1 (1)

where P is market value of equity, R = (1+r), r is the discount rate, and d is

net dividends. For simplicity we assume that investors are risk neutral with
respects to the risks associated with the firm and thus earn the risk free rate.
If we want to adjust for risk, we can incorporate risk in the numerators of
our models (i.e., adjust expected cash flows to reflect systematic risk).1
The following identity holds for any sequence of numbers:
0 = 0 + 1 (1 0 ) + 2 (2 1 ) + + ( 1 ) (2)
because 0 as T

Adding (1) and (2) gives:

0 = 0 +
=1 ( 1 + ) (3)

Setting = in (3) gives:

0 = 0 +
=1 ( 1 + ) = 0 + =1 ( 1
1 + ) (4)

where b is book value of equity

But according to clean surplus accounting

1 = (5)
where e is comprehensive income

See, Feltham and Ohlson (1999), Feltham and Ohlson (1995), and Penman (1998)

Financial Statement Analysis T3 2015/2016

Replacing (5) in (4) gives:

0 = 0 +
=1 ( 1 )

which is the RIM

Financial Statement Analysis T3 2015/2016

B. Equivalence of DDM and Discounted Cash Flow (DCF) model

Setting yt = fat in (3) gives:

0 = 0 +
=1 ( 1 + ) (6)

where fa is net financial assets; fa becomes negative for net debt

We know that:
= ( 1 ) (7)
where fcf is free cash flows and oa is net operating assets

We also know that:

= + (8)

Substituting (8) in (5) gives:

+ 1 1 = (9)

Subtracting (7) from (9) gives:

+ 1 1 = + 1
1 = = 1 + +
(10)
where i is net interest expense and equal to eps oi)

We know that:
= 1 (11)

Adding (10) and (11) gives:

= 1 + (12)

Financial Statement Analysis T3 2015/2016

Substituting (12) in (6) gives:

0 = 0 +
=1

which is the DCF model