INTRODUCTION

The modern corporation operates on the principle of shareholder value maximization. To create wealth for its owners, a firm must earn more on its invested capital than the cost of that capital. Firm stakeholders evaluate a firm's financial performance using various measures, such as revenues, earnings, cash flows, and return on investment. Residual income (RI) is a commonly used metric that captures the net surplus generated by the firm. RI and accounting-based net income (NI) share some similarities in that both RI and NI subtract operating expenses and taxes from revenues to arrive at profits. However, RI differs from NI in a crucial aspect: whereas NI defines profits net of interest expense, RI measures profits net of the cost of both debt and equity capital. Thus, RI accounts for the opportunity cost of the total capital employed in the business (Biddle, Bowen, and Wallace 1997, 1999).

Current accounting rules do not permit reflecting the cost of equity in reported income. Therefore, proponents of RI advocate adjusting reported income by subtracting an additional charge for the cost of equity. In combining income and opportunity cost, RI contrasts the factual course of action with the counterfactual course of action (Magni 2009). Since RI measures a firm's profit above the normal return required by investors, analysts and investors can use RI to determine whether managerial decisions generate positive economic value. Consistent with this notion, various parties use RI in equity valuation, capital budgeting, performance measurement, executive compensation, and tax planning. This chapter discusses the historical evolution and computation of RI, its application to equity valuation, and scholarly and practitioner critiques of the concept.

HISTORY AND FOUNDATIONS OF RESIDUAL INCOME

The concept of opportunity cost underpins modern economic theory. Opportunity cost is the potential gains or benefits that are forgone when a decision maker chooses one alternative over another. In more formal terms, a resource's opportunity cost is the value of the next-highest-valued alternative use of that resource. Deploying capital in an investment project results in a loss of profits that could have been earned had the capital been employed in an alternative investment opportunity. An investment opportunity must earn returns above its opportunity cost of capital to generate incremental value for the investor. This idea is the foundation of RI.

The concept of net surplus generated after accounting for the opportunity cost of capital is not new. Marshall (1890) discusses the notion of excess profit, likely motivated by Hamilton (1777), who, in turn, appears to have been influenced by Smith (1776). Therefore, RI can be traced back to the beginning of modern economic thought. Scholars in the late nineteenth and early twentieth centuries, such as Ladelle (1890), Leake (1921), Canning (1929), and Preinreich (1936, 1937, 1938), contributed to the development of the concept. In particular, Preinreich (1938) develops an analytical framework in which a project's capital value equals the sum of a project's current book value and discounted future excess profits. In this framework, excess profits are the difference between profit per unit of capital investment less interest per unit of capital investment. This concept is similar to the modern notion of RI.

Moreover, in a foreshadowing of the valuation application of RI, Preinreich (1938) discusses reconciling accounting numbers with capital values, as do Edwards and Bell (1961), Solomons (1965), and Peasnell (1982). In a related vein, Hicks (1946) develops the idea of “economist's income,” which focuses on the value of future cash flows after imposing an interest charge. In parallel with these academic developments, corporations such as General Motors, DuPont, and General Electric began adopting forms of RI for internal evaluation and control purposes (Lewis 1955; Solomons 1965).

Although RI attracted management accountants because of its use in performance evaluation and compensation, the concept did not initially draw much attention in valuation research. Seminal work by Ohlson (1991, 1995) and Feltham and Ohlson (1995, 1996, 1999) reintroduced RI to valuation scholars. Finance and valuation experts widely use the discounted dividends model (DDM) in which current equity value equals the discounted present value of expected dividends. Ohlson (1995) sought to draw a direct link between RI and the DDM so that accounting-based valuation could be grounded in finance theory. Feltham and Ohlson (1995) and Ohlson (1995) develop the “clean surplus relation” (CSR) in which changes in the book value of equity are set equal to earnings minus dividends, net of capital contributions. This assumption permits replacing dividends with earnings and book values in the traditional DDM. In the Ohlson (1995) framework, equity value is expressed as a weighted average of capitalized current earnings (adjusted for dividends) and current book value, thus giving a prominent role to RI in valuation.

Subsequent studies offered refinements to Ohlson's (1995) RI framework. For example, Feltham and Ohlson (1999) relax assumptions about investors' risk-bearing preferences and interest rates and provide a generalized version of the RI valuation model. Myers (1999) stresses using a linear information model, while Biddle et al. (2001) introduce capital investment dynamics, which set up net capital investment to be a function of current profitability and thereby influence future profits. O'Hanlon and Peasnell (2002) and Pfeiffer and Schneider (2007) are other examples of extensions and refinements to the RI framework. Along with the valuation role of RI, scholars also studied the incentive effects of RI. For example, Rogerson (1997) models the effect of different investment allocation rules on managers' investment incentives when basing managerial compensation on the income that includes allocations for investment expenditures. Rogerson shows that an allocation rule based on RI or economic value added induces managers to choose the most efficient investment level.

Similar to its slow acceptance in the academic community, and despite early enthusiasm among the business community, practitioners used RI on a limited basis in the early to mid-twentieth century. Surveys from the 1980s suggest that only about 10 percent of large corporations in the United States and the United Kingdom used some version of RI in investment selection and performance evaluation (Bromwich and Walker 1998). RI saw a revival in the business community in the 1990s, in part due to its promotion by Stern Stewart & Co., which developed its version of excess profits called economic value added (EVA) (Stewart 1991). Stern Stewart & Co. aggressively promoted EVA, claiming that EVA-based financial management systems had the potential to motivate the entire organization and not just senior management (Stern, Stewart, and Chew 1995; Stern, Shiely, and Ross 2001). Because computing RI requires many adjustments to reported financial accounting numbers, practitioners developed several versions of RI. For example, consulting firms such as McKinsey (economic profit), Boston Consulting Group (total business return or TBR), and A.T. Kearney (economic earnings) proposed their own sets of accounting adjustments with claims of making accounting numbers better measures for performance measurement and valuation.

In sum, RI has undergone a gradual yet substantial transformation from its early roots in classical economic theory to its current status, where practitioners widely apply RI not only to valuation but also to project planning, budgeting, performance measurement, and compensation.

COMPUTING RESIDUAL INCOME

Measurement of RI involves adjustments to accounting earnings reported in the firm's financial statements. Under generally accepted accounting principles (GAAP), the cost of debt financing is charged to earnings in the form of interest expense. However, GAAP does not allow any corresponding expense for equity financing. Therefore, some scholars and practitioners contend that reported earnings are an incomplete measure of the return on invested capital (ROIC), which includes both debt and equity. For example, if a project generates returns that exceed the cost of debt, then it can increase reported earnings while still reducing shareholder wealth unless the returns are more than the opportunity cost of equity capital. RI is designed to address such issues.

A key input to computing RI is net operating profits after tax (NOPAT), defined as earnings before interest and taxes (EBIT) adjusted for taxes. EBIT subtracts the cost of debt and taxes from net income (NI), which are then accounted for explicitly in computing RI. The other required input is the weighted average cost of capital (WACC), which is a weighted average of the costs of debt and equity, respectively, with the amounts of debt and equity acting as the respective weights. The cost of debt is computed on a post-tax basis. The sum of debt and equity constitutes the firm's total invested capital (TIC). Then, RI for period t is defined as in Equation 13.1:

(13.1)

where TIC (debt plus equity) equals a firm's total assets. Therefore, NOPAT can be alternatively expressed as return on assets (ROA) times TIC. Thus, Equation 13.1 can be expanded, as shown in Equation 13.2:

(13.2)

Rearranging Equation 13.2 yields Equation 13.3:

(13.3)

Equation 13.3 implies that the rate of return on TIC must be greater than the WACC to result in a positive RI. In other words, a project must have a positive “spread” between the return from the project and the cost of capital to generate incremental shareholder value.

Drawing a direct correspondence between RI and the traditional accounting NI is possible by noting that Equation 13.3 can be alternatively expressed as Equation 13.4:

(13.4)

where BV is the book value of equity and k is the cost of equity. Since NI already accounts for the cost of debt, subtracting the cost of equity from NI yields RI (Biddle et al. 1999).

Practitioners maintain that inputs into the RI calculation, such as accounting earnings and book value, suffer from biases and need adjustments before using them when computing RI. However, disagreement exists about the needed adjustments. For example, Stern Stewart's EVA calls for several steps such as capitalization and amortization of research and development (R&D) expenditures, adding back accounting depreciation and instead subtracting “economic” depreciation, capitalizing operating leases, adding back noncash expenses, and accounting for income taxes on a cash basis rather than accrual basis as required under GAAP. Because different versions of RI require different adjustments, a more tractable conceptual approach is to start from NOPAT, as in Equation 13.1.

Accounting earnings under GAAP have certain advantages that could be lost when adjusting NI or NOPAT when computing RI. Accounting earnings are based on accruals, or accounting adjustments, that reflect managers' expectations of future performance. Past studies such as Bowen, Burgstahler, and Daley (1986) and Finger (1994) show that reported earnings are better predictors of firm performance compared with cash flows that are stripped of accruals. Even if certain adjustments to reported earnings are warranted, investors may use a different set of adjustments than those recommended under a given variant such as EVA. Further, the market may use the cost of capital estimates that differ from those chosen by a specific user. Finally, the market may not recognize the incremental information contained in RI. Although this lack of recognition could result in valuation estimates that differ from the current market values, it could also create profitable investment opportunities for savvy investors.

EQUITY VALUATION USING RESIDUAL INCOME

The DDM is the bedrock of modern valuation theory. Ohlson (1995) relates this valuation theory to accounting by proposing that net equity value at any point in time should reconcile with the creation and distribution of shareholder value as captured by the accounting system. This idea stems from a “clean surplus relation” (CSR) in which all changes in equity value are reflected through the income statement and dividends. The Ohlson (1995) framework assumes away “dirty surplus,” which covers changes in equity that bypass the income statement and appear directly in the shareholders' equity account in the balance sheet. For example, the dirty surplus may include items contained in other comprehensive income (OCI) such as gains and losses on pensions and foreign currency translation adjustments. Ohlson defines RI as earnings minus a charge for using capital, measured as beginning-of-period book value multiplied by the cost of capital. In this framework, equity value is the sum of the current book value and capitalized future RI.

To reconcile RI-based valuation with the traditional DDM, recall that DDM expresses the market value of equity as the net present value (NPV) of future dividends as shown in Equation 13.5:

(13.5)

where V_t is the market value of equity at time t; D_t+n signifies the cash dividend paid out at future date n period ahead; and k represents the discount rate used to calculate the present value of dividends (i.e., the cost of equity). The key to forging a link between RI valuation and the DDM is to transform dividends as a function of accounting constructs such as book value of equity. To do so, Ohlson's (1995) CSR assumption implies that changes in the book value of equity are solely a function of net income and dividends. Specifically, CSR implies Equation 13.6:

(13.6)

which can be rearranged to yield Equation 13.7:

(13.7)

Further, net income can be expressed as a function of RI, book value of equity, and the cost of equity by rearranging the definition of RI in Equation 13.4 to produce Equation 13.8:

(13.8)

Substituting the above value of NI_t into Equation 13.7 and rearranging terms leads to the following expression for dividends in Equation 13.9:

(13.9)

Substituting the value of dividends thus obtained back into the DDM valuation Equation 13.5 leads to Equation 13.10:

(13.10)

This seemingly complicated expression can be simplified by recognizing that discounted present values decrease in magnitude rather quickly by projecting sufficiently far into the future. In other words, assuming that BV_t+n/(1 + k)ⁿ gets close to zero as n approaches ∞, then Equation 13.10 becomes Equation 13.11:

(13.11)

This equation is the familiar formulation in Ohlson (1995), which states that the current equity value is a sum of the current book value of equity and capitalized future RI. A conceptual problem with this approach is that while the current book value of equity is observable, expected RI in future periods is unknown. To solve this problem, Feltham and Ohlson (1996) propose that future RI is related to current RI via a stochastic process termed linear information dynamics (LID). This evolutionary path for RI simplifies the valuation process by expressing current firm value as a weighted average of current book value and capitalized current earnings (adjusted for dividends). This extension makes mapping Ohlson's (1995) RI framework into reality easier. Computing RI and its use to value the market value of equity is illustrated next using a numerical example.

NUMERICAL EXAMPLE

As discussed earlier, computing RI involves subtracting the opportunity cost of capital from profits, which can be done in two ways. One way is to subtract the opportunity cost of equity capital from NI, which already accounts for the cost of debt. The other way is to subtract the weighted average cost of total capital, which includes both debt and equity, from NOPAT. The following numerical example illustrates the two approaches.

Suppose P&D Inc. has total invested capital of $10 million, consisting of $6 million in debt and $4 million in equity (i.e., the debt-to-total capital ratio is 0.60). The cost of debt is 6 percent and the opportunity cost of equity is 10 percent. For the year under review, assume that EBIT is $1,200,000 and the tax rate is 40 percent.

* WACC = [(After-tax cost of debt × Debt) + (Cost of equity × Equity)]/(Debt + Equity) = [(6% × (1 – 40%) × $6,000,000) + 10% × $4,000,000)]/($6,000,000 + $4,000,000) = [3.6% × $6,000,000 + 10% × $4,000,000]/$10,000,000 = 6.16%.

This value of RI can be substituted into the valuation equation (13.11) to obtain the firm's market value. For simplicity, assume no growth in RI over time (i.e., current and future RI values are constant at $104,000). As discussed earlier, the market value of the firm's equity can be expressed as the sum of the current book value of equity ($4,000,000) and the present value of the stream of future RIs ($104,000) discounted at the cost of equity (10 percent). Therefore:

Simplifying the summation of the infinite stream of discounted annuity:

APPLYING RI TO EQUITY VALUATION

Soon after the publication of Ohlson (1995), scholars and practitioners began to evaluate the model's validity, as well as ways to estimate it empirically. For example, Frankel and Lee (1998) use analyst earnings forecasts to operationalize expected future income to compute expected RI. They examine the usefulness of RI for predicting cross-sectional stock returns and find positive correlations between such earnings estimates and contemporaneous stock prices. Moreover, the authors also find that the value-to-price ratio based on RI estimates is a good predictor of long-horizon returns. However, tests of the LID inherent in Ohlson do not always yield consistent results. For example, Dechow, Hutton, and Sloan (1999) report evidence consistent with a mean-reverting RI process but note that LID is not necessarily superior to simply capitalizing one-period-ahead earnings in explaining equity values. Similarly, Myers (1999) examines several formulations of LID to find that none outperformed the book value of equity alone. Such inconsistencies led to scholars such as Verrecchia (1998), Beaver (1999), Lee (1999), and Lo and Lys (2000) to call for a theory-based exploration of factors that influence RI and situations in which the Ohlson model would be applicable.

In response, several studies tried to address the model's potential limitations by infusing it with “real-life” dynamics. For example, Baginski and Wahlen (2003) adapt the model to situations where obtaining the cost of capital estimates is difficult because market-based risk measures are unavailable. Cheng (2005) examines how economic rents and conservative accounting affect RI and develops a measure of abnormal return on equity (ROE). He then examines whether integrating the determinants of abnormal ROE into the RI valuation model can improve its ability to explain the firm value. Heinrichs, Hess, Homburg, Lorentz, and Sievers (2013) extend the RI valuation model to incorporate real-world factors such as dirty surplus accounting and examine the consequences for terminal value modeling. They report that their extended model significantly improves the valuation accuracy of the RI model.

Overall, despite limitations, practitioners use Ohlson (1995) and Feltham and Ohlson (1996) for equity valuation in various settings. For example, besides the studies discussed previously, which generally focus on industrial firms, Begley, Chamberlain, and Li (2006) and Stoughton and Zechner (2007) apply RI valuation techniques to financial institutions, including banks. Balachandran and Mohanram (2012) decompose earnings growth into growth in RI, growth in invested capital, and other components. They then use this decomposition to explain the observed stock returns. The authors claim that their approach is superior for explaining stock returns compared with a simple regression of stock returns on accounting earnings. In an applied valuation setting, Knauer, Silge, and Sommer (2018) focus on applying value-based management, which is a variation on the RI model, to mergers and acquisitions (M&As), and report that the market responds more positively to acquisition announcements by firms that implement value-based metrics. The breadth and depth of the applications discussed earlier suggest that the RI valuation model is a useful framework for linking accounting numbers with firm value and thus provides a direct link between accounting numbers and finance theory.

EVALUATION AND CRITIQUE OF RESIDUAL INCOME

Scholars and practitioners criticized RI even before academic research such as Ohlson (1995) and consulting firms such as Stern, Stewart, & Co. popularized the concept. Academic critiques of RI are related to construct validity and the correspondence with other valuation frameworks such as the DDM, while practitioners raised concerns over implementation aspects such as using an appropriate cost of capital estimate and the accounting adjustments necessary to compute a reliable RI measure. Construct validity refers to the degree to which a test measures what it purports to measure.

As discussed previously, the Ohlson (1995) model was initially met with enthusiasm. Early empirical research, including Bernard (1995), Penman and Sougiannis (1998), and Francis, Olsson, and Oswald (2000), finds that the model explained stock prices better than alternative valuation models based on dividends and cash flows. As Frankel and Lee (1998) note, the Ohlson model provides a comprehensive and rigorous theory-based valuation approach. However, subsequent examinations point out its shortcomings. For example, consistent with Ohlson's information dynamics, Dechow et al. (1999) find that RI follows a mean-reverting process, which is reflected in stock prices, implying that the book value of equity conveys additional information over earnings in explaining contemporaneous stock prices. However, they also find that the RI model provides only minor improvement in explanatory power over the traditional valuation approaches such as the DDM. According to Lee (1999), the main challenge in valuation is forecasting future earnings. The Ohlson model does not offer much guidance in this aspect since it does not directly relate financial statement numbers to firm value. Key inputs to RI valuation, such as future expected abnormal earnings, are forecasts, not actual realizations of earnings, and the CSR link among dividends, book value, and earnings are insufficient to implement RI valuation. Bernard (1995) discusses how a second link between current accounting numbers and future RI is an essential part of fundamental analysis, which is missing in RI valuation. To overcome this problem, Ohlson introduces the idea of LID, which assumes a stochastic process for future abnormal earnings and nonaccounting information based on their historical realizations. However, the extent to which this theoretical assumption plays out in real-world data is an empirical question.

Another issue with Ohlson (1995) is that the model assumes unbiased accounting, implying that historical earnings are a reliable predictor of future earnings. If accounting systems are biased due to GAAP requirements or because of managerial discretion, then average abnormal earnings will be nonzero. Given conservative accounting, reliably predicting future growth in book value becomes a critical component of the model. Lee (1999) observes that Feltham and Ohlson (1995, 1996) modify the original LID assumptions to allow current book value to provide information about future RI. However, these simplifications and additional assumptions do not necessarily reflect reality. Myers (1999) further points out that empirical studies making ad hoc modifications to the linear information models contain internal inconsistencies and violate the no-arbitrage assumption. Myers also reports that the Ohlson (1995) and Feltham and Ohlson (1995) models provide equity value estimates that are no better than book value alone.

Lo and Lys (2000) echo some of these sentiments in discussing the logical and empirical challenges in RI valuation. For example, similar to Myers (1999), they note that many empirical studies implement the model without the information dynamics that are the key feature of the framework. Lo and Lys also show that RI valuation imposes data requirements that are difficult to meet in actual empirical settings. As a result, tests of RI valuation require approximating the model's requirements. However, the consequences of such approximations on the model's predictions are difficult to assess. As a result, rejecting RI valuation can lead to concluding that the test approach is flawed or the data are bad, but not that the model is wrong.

Lundholm and O'Keefe (2001) compare the traditional DCF model and RI valuation framework, which yield different estimates of equity value in prior studies. This finding is puzzling since both DCF and RI models are derived from the same underlying assumptions (i.e., that stock price is the present value of expected future net dividends discounted at the cost of equity capital). As Lundholm and O'Keefe note, most studies divide the valuation exercise into two periods: (1) a finite period, where various line items in financial statements are forecasted and each year's valuation metric (free cash flow or RI) is separately discounted; and (2) a terminal period, where the financial statement forecasts and valuation metrics are represented as a summary measure (e.g., growth at a constant rate in perpetuity). Ali, Hwang, and Trombley (2003) offer a similar view.

Lundholm and O'Keefe (2001) identify several errors with actually implementing this approach. Some studies assign incorrect amounts to the perpetuity of valuation metrics, leading to inconsistent forecast errors. The DCF and RI models reflect these errors in different ways, causing divergence in value estimates. The second type of implementation error is the incorrect discount rate error. This error arises from a potentially faulty approach in which first the value of the whole firm is computed by discounting firm-level CF or RI using the WACC. Then the analyst backs out the value of equity by subtracting the value of debt from total firm value. However, the correct discount rate is a weighted average of the cost of equity and the cost of debt with carefully chosen weights. Violating this condition can result in a discount rate that is inconsistent with the DDM, causing differences in the estimated values generated by the DCF and the RI frameworks. Another type of error, called the missing cash flow error, occurs when the financial statement forecasts do not satisfy CSR (i.e., when net income minus net dividends does not equal the change in shareholders' equity). The existence of dirty surplus can cause a divergence between future dividends implied by the RI model and those forecasted in the DCF model. As Lundholm and O'Keefe note, many empirical studies suffer from one or more of these errors, leading to internally inconsistent and inaccurate value estimates.

Although some scholars criticize the RI valuation model on theoretical and practical grounds, others defend the model and point out its relative advantages in specific settings. For example, Jiang and Lee (2005) discuss attributes of the RI model that make it suitable for equity valuation, particularly for studying stock price volatility. In the DDM approach, stock prices are a function of discounted expected dividends. However, cash dividend levels tend to be constant and sticky, and therefore have limited explanatory power for the observed volatility in stock prices. The RI valuation model is derived from the DDM by replacing dividends with earnings and book value, which are inherently more volatile when compared with dividends and hence provide a natural link to stock price volatility. Another advantage of using accounting numbers rather than dividends is that many firms, especially high-tech and growth firms, do not pay cash dividends, at least in the early stages of their life cycle. Therefore, although the DDM may not apply to such firms, the RI model can still be implemented as long as the current book value and future RI estimates are available. The CSR underpinning the RI model takes a broader view of dividends as the difference between earnings and changes in the book value. Therefore, the RI model can more easily reflect changes in share repurchases and other forms of cash payouts by way of the change in book value. Such transactions cannot be easily accommodated in the DDM.

According to Jiang and Lee (2005), the biggest strength of the RI model is that it shifts the focus away from the distribution of wealth (i.e., dividends) to the creation of wealth (i.e., book value and abnormal earnings). A firm's operations drive wealth creation as opposed to the firm's financing choices. The RI framework can naturally integrate dividend policy irrelevance. Since the firm pays dividends out of book value, not current earnings, RI is invariant to changes in the dividend policy. Jiang and Lee suggest that the RI model performs as well as the DDM, and is superior in some settings, in explaining stock price volatility. On the whole, although the criticisms of the RI valuation model highlight its conceptual and practical shortcomings, some scholars believe that the RI model is a superior valuation technique in some settings.

SUMMARY AND CONCLUSIONS

RI is the net surplus generated by an investment project after accounting for the opportunity cost of invested capital. For a project to have a positive RI and create value for the owners, it must generate returns that exceed its cost of capital. Accounting rules allow for charging the cost of debt to income in the form of interest expense. However, GAAP does not allow subtracting the cost of equity as an expense, leaving accounting net income as a potentially incomplete measure of the return on investment. Some scholars and practitioners contend that net income also suffers from other biases due to the prevailing accounting rules such as expensing R&D and the treatment of one-time charges and discontinued items. Therefore, advocates of RI recommend adjusting the accounting net income to remove potential biases and then subtracting the cost of equity to arrive at a more appropriate measure of performance. Since RI measures profits above the required rate of return, it can be used to evaluate value creation through managerial decisions. Accordingly, practitioners use RI for equity valuation, project management, budgeting, performance measurement, executive compensation, and tax planning.

Despite its apparent strengths as a measure of value, RI is subject to criticism for its potential theoretical inconsistencies and practical limitations. Prior studies find that the RI valuation model provides only minor improvement in explaining firm value over accounting numbers such as book value or the traditional DDM. A major issue is that key inputs to RI valuation, such as future expected abnormal earnings, are forecasts that are unavailable from a firm's financial statements. The real challenge in valuation is accurately forecasting future performance, where the RI model does not offer much help. Practically implementing the RI model involves adjusting accounting earnings for potential biases. However, ad hoc modifications can be internally inconsistent. Another practical challenge is selecting an appropriate cost of equity, which is difficult to estimate. Due to these limitations, the RI valuation model can generate estimates that are inaccurate and different from estimates generated by traditional valuation methods, such as the DDM.

Despite these criticisms, the RI model has certain advantages. For example, it can be applied to firms that do not pay dividends, which makes applying the DDM impractical. Another strength of the RI model is that it focuses on RI, which measures the creation of wealth, rather than on dividends, which represent the distribution of wealth. This characteristic makes the RI framework particularly suitable for operational planning, performance management, and compensation, besides its valuation role. Also, the DDM has limited explanatory power regarding stock price volatility because cash dividends are generally stable and persistent over time. Therefore, scholars and practitioners should evaluate the relative advantages and disadvantages of different valuation techniques, including RI, and choose the one that is best suited for the task at hand.

DISCUSSION QUESTIONS

1. Define RI and discuss how to measure it.
2. Discuss the types of adjustments to reported financial statement numbers needed when calculating RI, and why such adjustments are needed.
3. Discuss how RI is applied to equity valuation.
4. Explain the advantages of RI valuation over traditional approaches such as the DDM.
5. Explain the disadvantages of RI valuation compared with traditional approaches such as the DDM.

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