Management

g
S C A N D I N AV I A N J O U R N A L O F

Scand. J. Mgmt. 18 (2002) 303–318

www.elsevier.com/locate/scajman

Firm valuation: comparing the residual income

and discounted cash flow approaches
Thomas Plenborg*
Department of Accounting and Auditing, Copenhagen Business School, Solbjerg Plads 3,
2000 Frederiksberg, Denmark
Received 1 February 2000; accepted 1 February 2001

Abstract

This study compares the discounted cash flow approach and an accrual based valuation
approach: the residual income model. Given the theoretical equivalence between the residual
income and discounted cash flow approaches this, study examines whether it is possible to
infer a valuation approach that is superior to the other from a user perspective. The two
valuation approaches are compared on the basis of analytical attractiveness. This study
demonstrates that if practitioners introduce simplifying assumptions in their firm valuation,
they also introduce biases in their firm value estimates. In some cases the residual income
approach yields more accurate firm value estimates, while in others the discounted cash flow
approach yields more accurate estimates. Further, the impact of simplifying assumptions on
firm value estimates can be significant. Thus, it is important that practitioners introducing
simplifying assumptions are aware of the impact on firm value estimates. Finally, since the
framework for forecasting is often based on accrual accounting and the budget control is
generally based on accounting numbers rather than cash flow numbers, it seems logical to
estimate firm values based on concepts known from accrual accounting and financial statement
analysis, i.e. the residual income approach. r 2002 Elsevier Science Ltd. All rights reserved.

1. Introduction and motivation

In the past decade, the residual income approach (RI)1 and the discounted cash
flow approach (DCF)2 have received considerable attention. Despite the theoretical

*Fax:+45-3815-2321.
E-mail address: tp.acc@cbs.dk (T. Plenborg).
1
The residual income approach has also been labelled the EBO model and/or the residual earnings
model.
2
The RI approach is introduced in Edwards and Bell (1961) and Ohlson (1995). The DCF approach can
be found in most finance textbooks. See, e.g. Copeland et al. (1990).

0956-5221/02/$ - see front matter r 2002 Elsevier Science Ltd. All rights reserved.
PII: S 0 9 5 6 - 5 2 2 1 ( 0 1 ) 0 0 0 1 7 - 3
304 T. Plenborg / Scand. J. Mgmt. 18 (2002) 303–318

equivalence between the RI and DCF approaches,3 the finance literature has argued
in favour of the DCF approach for firm valuation since it is unaffected by accounting
methods (Copeland, Koller, & Murrin, 1990). However, as demonstrated in Ohlson
(1995) the RI approach is insensitive to different accounting methods if clean surplus
accounting4 is applied in the forecasted financial statements. Recently, Penman and
Sougiannis (1998) and Francis, Olsson, and Oswald (2000) examined empirically the
accuracy of the RI and DCF approaches. Both studies find that the RI approach
yields more accurate firm value estimates than the DCF approach. However, since
both valuation approaches are based on the same theoretical framework, a proper
implementation would imply that both approaches yield similar firm value estimates.
It is difficult to infer from prior literature whether one valuation approach is
superior to the other. Given the theoretical equivalence between the RI and DCF
approaches, this study examines whether it is possible to infer a valuation approach
that is superior to the other from a user perspective. This question is addressed in
two ways. First, Olsson (1998) points out that simplifying assumptions5 are often
introduced when different valuation approaches are implemented in practice. Since
simplifying assumptions introduce bias in the firm value estimates, they are likely to
affect firm value estimates based on the RI and DCF approaches differently. Levin
and Olsson (2000) demonstrate that if the steady state condition is not reached when
the terminal value is calculated, the RI approach yields more accurate firm value
estimates than the DCF approach. This study therefore examines whether one of the
valuation approaches is systematically superior to the other when simplifying
assumptions are introduced. Second, an attractive valuation approach should be
easy to use and understand and it should help the user to perform better firm value
estimates (Penman & Sougiannis, 1998). For example, valuation approaches which
are based on measures that show the value creation rather than the value distribution
are easier to understand and interpret and are therefore analytically attractive
(Penman, 1992). Thus, this study evaluates whether the two valuation approaches
are analytically attractive from a user perspective.
This study demonstrates that simplifying assumptions affect firm value estimates
differently. In some cases the RI approach yields more accurate firm value estimates,
while in others the DCF approach yields more accurate estimates. The study also
shows that each of the assumptions examined affects firm value estimates in a
manner that can be predicted. For example, when the growth term applied for the
terminal value calculation is different from the growth term applied in the forecasted
financial statements, the RI approach yields more accurate firm value estimates than
the DCF approach. In that regard the results of Penman and Sougiannis (1998) and
Francis et al. (2000) can be predicted, since both studies introduce simplifying

3
Theoretical equivalence is the fact that based on stringent assumptions both the RI and DCF approach
yield identical firm value estimates.
4
Clean surplus accounting means that all revenues and expenses are recorded in the income statement;
in other words, the only items affecting owner’s equity are capital contributions, dividends, and income
that is recognised in the income statement.
5
The introduction of a simplifying assumption implies that the internal coherence between the
forecasted financial statements and the valuation approach (including cost of capital) is not intact.
 T. Plenborg / Scand. J. Mgmt. 18 (2002) 303–318 305

assumptions. Finally, this study argues that since the framework for forecasting is
based on accrual accounting and since budget control is generally based on
accounting numbers rather than cash flow measures, it seems logical to estimate firm
values based on concepts and financial ratios known from accrual accounting and
financial statement analysis, i.e. the RI approach.
The research question addressed in this study has practical importance. If
simplifying assumptions are introduced in firm valuation, this study demonstrates
that it is crucial to know the impact on firm value estimates. Depending on the type
of assumption introduced, the impact on firm value estimates can be significant.
The remainder of this study explains the logic underlying the conclusions outlined
above.

2. The theoretical equivalence of the RI and DCF approaches

The basic model for firm valuation is the dividend discount model (DDM) (Miller
& Modigliani, 1961). When investors buy stocks, they expect to receive two types of
cash flow: dividend in the period during which the stock is owned, and the expected
sales price at the end of the period. In the extreme example, the investor keeps the
stock until the company is liquidated; in such a case, the liquidating dividend
becomes the sales price. Under the assumption of an infinite time horizon, the DDM
can be expressed as

X
N
divt
P0 ¼ ; ð1Þ
t¼1
ð1 þ ke Þt

where P is the firm value, div the dividends, and ke the cost of capital (equity-holder).
The estimated market value of a firm’s equity should be unaffected by the
valuation approach applied, so it is important to ensure that the valuation
approaches are conceptually equivalent to one another. Since the DDM is the
theoretically correct model, it may be surprising to some that considerable effort and
resources are employed to develop alternative valuation approaches. One reason is
that under the DDM, dividends are treated as the distribution rather than the
creation of wealth. Penman (1992, p. 467) describes it as the dividend conundrum
‘price is based on future dividends but observed dividends do not tell us anything
about price’. Ideally, the valuation approach chosen incorporates those variables
that show the creation of wealth rather than the distribution of wealth. Among other
things, this will ease the interpretation of firm value estimates for both financial
analysts and end-users (investors).
The RI approach was introduced by Edwards and Bell (1961) and subsequently
further developed by Peasnell (1982) and Ohlson (1995). It is derived from the
DDM. RI is a variation of the better-known EVA approach (Stewart, 1991); it
measures firm value from an equity-holder’s perspective rather than from a lender’s
and an equity-holder’s perspective (EVA approach). The RI approach can be
306 T. Plenborg / Scand. J. Mgmt. 18 (2002) 303–318

expressed as

X
N
NIt  ke  BVt1
P0 ¼ BV0 þ : ð2aÞ
t¼1
ð1 þ ke Þt

The RI approach can also be expressed in terms of financial ratios:

X
N
ðROEt  ke ÞBVt1
P0 ¼ BV0 þ ; ð2bÞ
t¼1
ð1 þ ke Þt

where NI is the net income, BV the book value of equity, and ROE the return on
equity.
To summarise, the RI approach in (2a) and (2b) consists of two terms: the book
value of equity at the valuation date and the present value of future residual income.
For this purpose, residual income is defined as the difference between ROE and ke
multiplied by the book value of equity. As either the growth rate in book value6 or
residual income increases, the difference between a firm’s estimated value and its
book value increases. In other words, investors are only willing to pay a premium
above the book value of equity if it is possible to earn a rate of return on equity
beyond the equity cost of capital (i.e. the firm produces positive residual income).
The DCF approach can be found in most financial textbooks (Rappaport, 1986;
Copeland et al., 1990)7. Penman (1997) demonstrates that the DCF and the RI
approach are theoretically equivalent. Based on DCF, it is possible to estimate firm
value from an equity-holder’s perspective (DCFE):

XN
FCFEt
P0 ¼ þ cash assets; ð3aÞ
t¼1
ð1 þ ke Þt

where FCFE is the free cash flow to equity-holders.

The DCF approach can also be stated in a form that reflects the overall value of
the firm, including the interests of both debt and equity-holders (DCFF):

X
N
FCFFt
EV0 ¼ ; ð3bÞ
t¼1
ð1 þ WACCÞt

where EV is the firm value (both interest bearing debt and equity), FCFF the free
cash flow to the firm (both equity-holders and lenders), and WACC the weighted
average cost of capital. (3a) and (3b) yield identical equity value estimates if
consistent assumptions are made about growth in the two cash flow approaches and
if interest-bearing debt is correctly priced.
6
Growth only affects the value if ROE and ke are different.
7
There is growing tendency among Danish financial analysts to apply the DCF approach as a primary
tool for firm valuation (Fejer & Sparup, 1995).
 T. Plenborg / Scand. J. Mgmt. 18 (2002) 303–318 307

3. Do the RI and DCF approaches yield identical firm value estimates in practice?

Bernard (1995), employing only the first 4 yr of forecast data, finds that the RI
approach explains 68 per cent of a firm’s stock price, while the DDM explains only
29 per cent. Using a slightly different approach, Plenborg (1999) finds similar results
when comparing the information content of earnings and cash flows. On the basis of
Danish data, Plenborg finds that four years of accumulated earnings explains 22 per
cent of the stock price variation in the same measurement period. In comparison,
accumulated free cash flows explain less than 1 per cent of the stock price variation
in the same four-year period. The results of both Bernard and Plenborg indicate that
the required forecast period is shorter for the RI approach than for the DDM/DCF
approach.
Penman and Sougiannis (1998) and Francis et al. (2000) compare the reliability of
firm value estimates based on the DDM, RI and DCF approaches, respectively.
Although both studies use US data, a primary difference between them is that the
forecast data are determined differently. Francis et al. use Value Line’s forecast data
while Penman and Sougiannis apply realised data as estimates of historical
forecasts.8 Despite the different sources of forecast data, both studies show that
the RI approach yields less biased firm value estimates than the DDM and the DCF
approaches. This result is insensitive to different methods for calculating the terminal
value. However, the RI approach did not perform particularly well when terminal
value calculations are important. This is the case when the book value of equity is a
bad indicator of firm value.
The Penman and Sougiannis (1998) and Francis et al. (2000) studies suggest that
the RI approach yields more accurate firm estimates than the DDM and the DCF
approaches. However, their findings conflict with the finding in Section 2 that the RI
and DCF approaches are both inherently based on the DDM and thus, from a
theoretical perspective, should yield the same firm value estimates. Plenborg (2000)
also finds that the three valuation approaches generate the same point estimate of
firm value in practice, if the same assumptions are applied. This indicates that neither
Penman and Sougiannis nor Francis et al. have taken into account that the same
assumptions must be applied. An examination of their test methods also indicates
that this is the case. For example, the growth rates used to estimate the terminal
value are arbitrarily set at 0 and 4 per cent in both studies. Thus, the link between the
forecasted financial statements and the input in the different valuation approaches is
most likely inconsistent. Further, both studies seem to ignore that growth generally
affects the free cash flow negatively. They adjust the growth rate without a
corresponding adjustment of the free cash flow. Finally, the DCF approach
measures firm value from a combined equity-holder and lender perspective, while the
RI approach measures firm value from an equity-holder’s perspective only. As
shown by Damodaran (1994, p. 146), the growth rate does not have to be identical in
the two valuation approaches due to the effect of leverage.

8
Penman and Sougiannis (1998, p. 354) discuss the advantages and disadvantages of these two
forecasting methods.
308 T. Plenborg / Scand. J. Mgmt. 18 (2002) 303–318

Although the tests performed by Francis et al. and Penman and Sougiannis are no
better than the assumptions on which they are based, the results do provide some
useful insights into firm valuation. If the valuation approaches are not properly
employed (as with the growth rate used in the terminal value calculations), the
approaches yield different firm value estimates. This is also stressed by Olsson (1998,
p. XII): ‘..one typically makes different simplifying assumptions along the road when
implementing the different modelsFand different assumptions may cause quite
substantial differences in the resulting value estimates’. Further, the studies of
Penman and Sougiannis and Francis et al. indicate that if the internal coherence
between the three valuation approaches is violated, the RI approach should be
preferred for firm valuation at the expense of the DDM and DCF approaches. The
question is, however, whether the findings in both Penman and Sougiannis and
Francis et al. can be generalised to all types of simplifying assumptions, or whether
the findings are a result of the simplifying assumptions introduced in the studies
concerned. This issue is addressed in the following section.

3.1. The impact of simplifying assumptions (misspecification) on firm value estimates

This section explores the consequences of simplifying assumptions on firm value

estimates based on RI and DCF, respectively. While a range of simplifying
assumptions could be considered, this study is inspired by Penman and Sougiannis
and Francis et al. As indicated above, Penman and Sougiannis and Francis et al.
make a number of simplifying assumptions where the internal coherence between the
forecasted financial statements and the valuation approaches is violated. This leads
to biased firm value estimates. Few of the assumptions are as follows:
1. Arbitrary growth assumptions for terminal value calculations.
2. The use of long-term (target) capital structure in the WACC calculation (rather
than the use of weights implied by the forecasted balance sheet) and constant costs
of debt and equity (neglecting that the risk of the company changes as the market
debt to equity ratio changes).
Since theory suggests that cost of equity is a positive function of financial
leverage, a third type of simplifying assumption is examined as well.
3. The use of long-term (target) capital structure in the WACC calculation (rather
than the use of weights implied by the forecasted balance sheet) and adjusted cost
of equity (taking into account that the risk of the company changes as the market
debt to equity ratio changes).
In order to examine the effect of the three types of simplifying assumptions on firm
value estimates, an example is constructed where forecasted financial statements that
include the cost of capital are prepared.
The forecasted financial statements and cost of capital are shown in Table 1
(panel A). For simplicity, growth is assumed to be equal to zero. Since all other
value drivers are assumed to be constant across time, the growth rate is also
equal to 0 per cent in both the RI and DCF approaches. Taxes are ignored
 T. Plenborg / Scand. J. Mgmt. 18 (2002) 303–318 309

Table 1

Panel A Unbiased Panel B Conservative Panel C Liberal

accounting accounting accounting

Income statement 0 1 0 1 0 1
Sales 1000 1000.00 1000.00 1000.00 1000.00 1000.00
Operating expenses 780.00 780.00 780.00
Operating profit 220.00 220.00 220.00
Interest expenses 75.00 75.00 75.00
Net income 145.00 145.00 145.00
(ignore taxes)
Dividend 145.00 145.00 145.00
Retained earnings 0.00 0.00 0.00

Balance sheet 0 1 0 1 0 1
Assets 2000.00 2000.00 1000.00 1000.00 3000.00 3000.00

Shareholders equity 1000.00 1000.00 0.00 0.00 2000.00 2000.00

Interest bearing debt 1000.00 1000.00 1000.00 1000.00 1000.00 1000.00
Total liabilities 2000.00 2000.00 1000.00 1000.00 3000.00 3000.00

Cash flow statement

Operating profit 220.00 220.00 220.00
Investments 0.00 0.00 0.00
(invested capital)
FCFF 220.00 220.00 220.00
Net new debt 0.00 0.00 0.00
Interest expenses 75.00 75.00 75.00
FCFE 145.00 145.00 145.00
Dividends 145.00 145.00 145.00
Cash surplus 0.00 0.00 0.00
Cost of capital

Risk free rate 6%

Risk premium 5%
Beta debt 0.3
Beta assets 1.0
Beta equity 1.7
Cost of equity 14.50%
Interest rate 7.50%
Market value 50.00%
proportion of debt
Market value 50.00%
proportion of equity
WACC (market value) 11.00%

and the assumptions underlying the RI and DCF approaches are fulfilled. Given
the capital structure in the forecasted financial statement the cost of debt is
7.5 per cent, the cost of equity is 14.5 per cent and the WACC is 11 per cent.
Given these assumptions the RI and DCF approaches generate the same firm value
310 T. Plenborg / Scand. J. Mgmt. 18 (2002) 303–318

estimate:
0
RI ¼ 1000 þ ¼ 1000;
0:145  0

220
DCF ¼  1000 ¼ 1000:
0:11  0
The internal rate of return is assumed to be equal to the cost of capital. Further, the
example is based on unbiased accounting.9 The estimated market-to-book ratio is
therefore 1.00. Based on the constructed financial statements and the cost of capital
in Table 1, the impact of the three types of simplifying assumptions on firm value
estimates is examined.

3.1.1. Arbitrary growth assumptions for terminal value calculations

In the first example the growth rate from the forecasted financial statements
deviates from the growth rate used in the terminal term of the RI and DCF
approaches. As pointed out above, this violates the internal coherence between the
forecasted financial statements and the RI and DCF approaches. In a related study,
Levin and Olsson (2000) demonstrates that if the parameters (value drivers) are not
constant in the terminal period, the growth rate in the forecasted financial statements
will not be constant and thus violates the assumption of a constant growth rate in the
terminal term. They show that it leads to biased firm value estimates. Further, the RI
approach seems to yield less biased firm value estimates than the DCF approach.
In order to examine the impact of the simplifying growth assumption, the growth
rate applied in the RI and DCF approaches is different from the 0 per cent growth
rate assumed in the forecasted financial statements. Specifically, the growth rate
deviates7 three percentage points from the growth rate assumed in the forecasted
financial statements. The result is illustrated in Fig. 1.
Since unbiased accounting is assumed in the example and the internal rate of
return equals the cost of capital, residual income is equal to zero. As mentioned
earlier, growth only affects the firm value if the residual income is either positive or
negative. The RI approach is therefore unaffected by the different growth rates
applied. On the other hand, the DCF approach is sensitive to the simplifying growth
assumption. When 3 per cent is used as the growth rate, the firm value estimate
exceeds the technically correct firm value estimate10 by 75 per cent. The example
illustrates the consequences if the effect of growth on free cash flows is ignored. The
firm value will be overvalued (undervalued) if the growth rate applied in the DCF
approach is larger (smaller) than the growth rate assumed in the forecasted financial
statements.11
9
Unbiased accounting is when residual income is purely a product of competitive (dis)advantage or
monopoly power (weakness).
10
In this context, a firm value estimate is technically correct if the internal coherence between the
forecasted financial statements and the different valuation approaches is intact.
11
This statement relies on a positive FCF in the terminal value and a growth rate that is lower than the
cost of capital.
 T. Plenborg / Scand. J. Mgmt. 18 (2002) 303–318 311

Fig. 1. Arbitrary growth assumptions for terminal value calculations and their impact on firm value.

It is rare that financial statements are based on unbiased accounting. In practice,

the accounting numbers are affected by conservative or liberal accounting (i.e. biased
accounting). If the financial statements are affected by conservative accounting
practice, this impacts financial ratios, including ROE. For example, consider two
companies that incur similar costs that will benefit future operations. One of the
companies considers the costs to be research expenses and the other considers the
costs to be property, plant, and equipment expenditures. Although both companies
generate the same cash flows, the firm that spends on R&D reports lower ROE in the
year of expenditure and higher ROE in subsequent years. Companies that apply a
conservative accounting practice will therefore experience higher ROE, except in the
year of initial expenditure. This is the case even when the internal rate of return on a
project equals the cost of capital. An example in which the discretion of management
in selecting accounting principles is liberal (optimistic), leads to a higher ROE in the
year of expenditure and lower ROE in subsequent years. Conservative and liberal
accounting therefore affect the level of residual income.
Since conservative and liberal accounting affect the level of residual income, the
above example is expanded to reflect the two types of accounting regimes. Panels B
and C in Table 1 represent conservative and liberal accounting regimes, respectively.
In the conservative accounting regime a more aggressive depreciation policy is
applied. This implies that assets and equity are reduced by 1000. In the liberal
accounting regime a more optimistic depreciation policy is applied. As compared
with the example based on unbiased accounting, assets and equity are increased by
1000. Given these assumptions and the simplifying growth assumption (7 three
percentage points), the RI approach generates the following firm value estimates (see
Fig. 2).12
When the growth rate applied in the RI approach is different from the 0 per cent
growth rate assumed in the forecasted financial statements, the firm value estimate
deviates from the technically correct firm value estimate. When 3 per cent is used as
the growth rate, the firm value estimate deviates by 26 per cent from the technically

12
Since the DCF approach is not affected by different accounting principles, only firm value estimates
based on the RI approach are reported
312 T. Plenborg / Scand. J. Mgmt. 18 (2002) 303–318

Fig. 2. Different capital structures and their impact on firm value.

correct firm value. In the case of conservative (liberal) accounting, the firm value
estimate is higher (lower) than the technically correct firm value estimate. Generally,
when RI is positive (reinforced by conservative accounting) the firm value will be
overvalued (undervalued) if the growth rate in the RI approach is larger (smaller)
than the growth rate assumed in the forecasted financial statements. On the other
hand, when RI is negative (reinforced by liberal accounting) the firm value will be
undervalued (overvalued) if the growth rate in the RI approach is larger (smaller)
than the growth rate assumed in the forecasted financial statements.13
A comparison of biases in the firm value estimates based on the RI and DCF
approaches reveals that the DCF approach is relatively more sensitive to the
simplifying growth assumption than the RI approach. The RI approach makes use
of the knowledge that has already been provided by the company in its financial
reporting (book value of equity). This implies that the RI approach places less
reliance than the DCF approach on the terminal term. The RI approach will
therefore generate more accurate firm value estimates than the DCF approach when
the simplifying growth assumption is introduced.

3.1.2. Target capital structure and constant costs of debt and equity
In the second example, the weights in the WACC formula are different from the
implied weights in the forecasted balance sheet (debt and equity)14 and the costs of
debt and equity are assumed to be constant across different capital structures. Both
Penman and Sougiannis and Francis et al. apply a target capital structure15 and
constant costs of debt and equity.16 However, in order to ensure theoretical
equivalence between the RI and DCF approaches, Levin and Olsson (1995) show
that the weights implied by the forecasted debt and equity should be applied. Ideally,
the cost of equity (and debt) should also be adjusted according to the capital
structure in order to reflect the underlying financial risk (Gregory, 1992). In a related
13
These statements assume that the growth rate is lower than the cost of capital in the terminal term.
14
Levin and Olsson (1995) refer to this as type 1 approximation error.
15
This is also in line with standard textbooks such as Copeland et al. (1990) and Damodaran (1994).
16
E.g. Francis et al. (2000, p. 52) calculate industry betas without adjusting for differences in financial
leverage across firms.
 T. Plenborg / Scand. J. Mgmt. 18 (2002) 303–318 313

Table 2
Cost of capital, given different target capital structures and constant costs of debt and equity (ignoring
taxes)

Debt/(Equity+Debt) (%) 1 25 50 75 99

Cost of debt (%) 7.50% 7.50 7.50 7.50 7.50

Cost of equity (%) 14.50% 14.50 14.50 14.50 14.50
WACC (%) 14.43 12.75 11.00 9.25 7.57

study, Levin and Olsson (1995) demonstrate that disregarding the fact that weights
in the WACC formula change when the debt ratio (in market values) changes, leads
to biased firm value estimates.17
In order to examine the consequences of applying a long-term (target) capital
structure and constant costs of debt and equity WACC has been adjusted to reflect
capital structures which deviate from the implied capital structure.
As illustrated in Table 2, the ‘target’ WACC is higher (lower) than the ‘implied’
WACC when the target capital structure is assumed to be lower (higher) than
the implied capital structure in the forecasted financial statements. The consequences
of this type of simplifying assumption on firm value estimates are illustrated in
Fig. 3.
Since the costs of debt and equity are assumed to be constant across different
capital structures, firm value estimates based on the RI approach are not affected by
this type of simplifying assumption. On the other hand, it affects firm value estimates
based on the DCF approach. If, for example, 25 per cent of the company’s financing
consists of debt (equity), the firm value estimate deviates from the technically correct
firm value estimate by 27 (38) per cent.

3.1.3. Target capital structure and adjusted costs of debt and equity
In the final example, the weights in the WACC formula are still different from the
implied weights in the forecasted balance sheet (debt and equity). In contrast to the
second example, however, the cost of equity is adjusted according to the capital
structure. Although neither Penman and Sougiannis nor Francis et al. adjust the cost
of equity for differences in financial leverage, this example is included since it is in
line with financial theory (Gregory 1992).
When a company is financed by debt and equity only and taxes are ignored as in
this example, the general relation between bequity ; basset and bdebt is (Gregory, 1992)

bequity ¼ basset þ ðbasset  bdebt Þdebt=equity;

where b is beta (measures the systematic risk of asset, debt and equity).
Holding basset and bdebt constant yields the following bequity (and cost of equity)
given different capital structures (see Table 3).
17
They demonstrate it by using the DCF approach.
314 T. Plenborg / Scand. J. Mgmt. 18 (2002) 303–318

Fig. 3. Different capital structures, adjusted cost of equity and their impact on firm value.

Table 3
Cost of capital, given different target capital structures and adjusted cost of equity (ignoring taxes)

Debt/(Equity+Debt) (%) 1 25 50 75 99

Risk free rate (%) 6.0 6.0 6.0 6.0 6.0

Risk premium (%) 5.0 5.0 5.0 5.0 5.0
Beta debt 0.3 0.3 0.3 0.3 0.3
Beta assets 1.0 1.0 1.0 1.0 1.0
Beta equity 1.0 1.2 1.7 3.1 70.3
Cost of equity (%) 11.0 12.2 14.5 21.5 357.5
Interest rate (%) 7.5 7.5 7.5 7.5 7.5
WACC (estimated) (%) 11.0 11.0 11.0 11.0 11.0

In the absence of taxes, WACC is constant across different capital structures. This
is expected since WACC is independent of the capital structure.18 Accordingly, the
DCF approach yields firm value estimates that are technically correct (see Fig. 4).
On the other hand, when financial leverage increases, the cost of equity increases
as well. Thus, if the target capital structure deviates from the implied capital
structure in the forecasted financial statements and cost of equity is adjusted
according to the target capital structure, the RI approach yields biased firm value
estimates. If, for example, 25 per cent of the company’s financing consists of debt
(equity) the firm value estimate deviates from the technically correct firm value
estimate by 19 (33) per cent.
While it is difficult to make a general statement (i.e. to suggest that one valuation
approach is superior to the other) on the basis of the above examples, it is clear that
misspecification of the parameters in the RI and DCF approaches affects firm value
estimates in a predictable manner. Two of the simplifying assumptions adopted by
Penman and Sougiannis and Francis et al. are examined in this study. As illustrated
by the above examples, the impact of these types of simplifying assumptions on firm
value estimates is more severe when the DCF approach is applied as compared with

18
WACC is based on the company’s operating risk.
 T. Plenborg / Scand. J. Mgmt. 18 (2002) 303–318 315

Fig. 4. .

the RI approach. In that respect, the results of both Penman and Sougiannis and
Francis et al. are predictable.

4. The forecast and budget control of accounting numbers and free cash flows

An important aspect of firm valuation is the quality of the forecasts. The variables
that need to be forecasted in the RI and DCF approaches are different, which implies
that financial analysts may focus on different issues when carrying out their firm
valuations according to one or the other approach. The ROE (accounting numbers)
is in focus in the RI approach, while free cash flows are in focus in the DCF
approach. Several recent studies have examined the prediction of earnings and cash
flows. Plenborg (1996) finds that the time series patterns of earnings are more stable
relative to various cash flow measures including free cash flows. Shroff (1998) finds
that earnings have lower variance, higher correlation with returns and higher
predictive ability for returns than cash flows. Finally, Dechow, Kothari, and Watts
(1998) find that current earnings by themselves are a better forecast of future cash
flows than the current cash flow. These results suggest that accrual accounting as a
concept smooth accounting-based performance measures. Thus, accrual-based
performance measures such as earnings and ROE are better indicators of future
performance than cash flow measures.
These findings may also explain why the value driver concept, which is based on
accounting numbers and financial ratios, is suggested for the forecasting of both
accounting numbers and free cash flows (Copeland et al., 1990; Stickney & Brown,
1999). As mentioned above, ROE is the primary value driver in the RI approach and
it is well established that the ROE can be decomposed into a number of ‘sub-value-
drivers’ like profit margin, asset turnover, interest yield and financial leverage.
Nissim and Penman (1999) illustrate a framework for decomposing the ROE.
Interestingly, financial analysts already focus on ROE. The RI approach, therefore,
meshes nicely with most of the financial statement analysis concepts used in practice.
The DCF approach focuses on the estimation of cash flows and therefore, focuses on
the value drivers that affect cash flows. There is often a connection between value
drivers that affect cash flows and the ratios employed in the financial statement
316 T. Plenborg / Scand. J. Mgmt. 18 (2002) 303–318

analysis, as is also illustrated by Nissim and Penman (1999). However, when a

forecast based on value drivers is transformed from accounting numbers into free
cash flows, some obvious links between the financial statement analysis and the DCF
approach are lost. For example, financial analysts rarely employ budget control of
free cash flows. On the other hand, it seems more intuitive (and more likely) that
budget control is based on accounting numbers and is summarised in financial ratios
that are based on accounting data. Since the framework for forecasting is based on
accrual accounting and since budget control is generally based on accounting
numbers rather than cash flow measures, it seems logical to estimate firm values
based on concepts and financial ratios known from accrual accounting and financial
statement analysis, i.e. the RI approach.

4.1. The ability to explain firm value estimates

Another important aspect of firm valuation is the ability to explain firm value
estimates in terms of variables employed. For example, valuation approaches that
are based on measures showing the creation rather than the distribution of value are
easier to understand and interpret and are therefore analytically attractive (Penman,
1992). Most financial text books recommend earnings and financial ratios based on
accounting numbers for performance measurement (such as ROE) at the expense of
cash flows (see White, Sondhi, & Fried, 1998). In the last decade there has been a
strong focus on the usefulness of cash flows and earnings in explaining
contemporaneous stock returns. Generally, earnings dominate cash flows in
explaining contemporaneous stock returns (see, e.g. Bernard & Stober, 1989; Ali,
1994; Dechow, 1994). Biddle, Bowen, and Wallace (1997) examine the relative
information content of earnings, cash flows, EVA and residual income. Biddle et al.
(1997) find that both earnings and residual income are relatively more informative
than cash flows. Thus, earnings and residual income seem to be better indicators of
performance than cash flows. Bernard (1989) argues that the problem with cash
flows is that positive cash flows can be both good and bad news, just as negative cash
flows can be considered as good and bad news. A positive residual income in the
forecast period suggests that the firm should be traded at a market-to-book ratio
beyond one. A positive free cash flow does not indicate whether a company should
be traded at a market-to-book ratio beyond one. Consequently, it also seems easier
to explain firm value estimates based on residual income than firm value estimates
based on free cash flows.

5. Conclusions

Since the RI and DCF approaches are theoretically equivalent, they both yield
identical firm value estimates if applied properly and consistently. If the valuation
approaches are not properly applied, they can easily yield biased firm value estimates
in practice. This study demonstrates that simplifying assumptions affect firm value
estimates differently. In some cases the RI approach yields more accurate firm value
 T. Plenborg / Scand. J. Mgmt. 18 (2002) 303–318 317

estimates while in others the DCF approach yields more accurate estimates. Given
the uncertainty surrounding firm valuation in practice, the use of simplifying
assumptions may seem acceptable. Levin and Olsson (1998, p. 287) argue that ‘one
sometimes hears comments to the effect that it is not worth the extra effort to use
correct and precise calculation techniques when valuing companies, since there is so
much uncertainty anyhow in the data that must ultimately be fed into the model’.
However, as illustrated in this study, the impact of simplifying assumptions on firm
value estimates may be significant. Accordingly, it is crucial that practitioners
introducing simplifying assumptions in their firm valuation are aware of the impact
of these on firm value estimates. In a related comment, Levin and Olsson (1998, p.
287) point out that ‘uncertainty is additive. The fact that there is a lot of uncertainty
in the data should really spur the analyst even more to what he or she can do to
reduce the over-all uncertainty’.
This study also argues that since the framework for forecasting is based on accrual
accounting and since budget control is generally based on accounting numbers
rather than cash flow measures, it seems logical to estimate firm values based on
concepts known from accrual accounting and financial statement analysis.
According to that criterion, the RI approach seems to be an attractive alternative
to the DCF approach.
Future researchers within this area may want to examine how practitioners apply
different valuation approaches. Since the impact of simplifying assumptions on firm
value estimates may be significant, and since the introduction of simplifying
assumptions affects firm value estimates in a predictable way, an understanding of
the extent and types of simplifying assumptions introduced by practitioners is
valuable.

Acknowledgements

This paper has benefited from comments and suggestions from Jeffrey Gramlich,
Johannes Mouritsen and Christian Petersen.

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