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The residual income model cannot challenge the discounted cash flow method in stock valuations - an analysis of global manufacturing and service companies

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  • Andras Takacs
  • Edina C. Erb

Abstract

The residual income model (RIM) exists in the literature as a theoretical concept for almost a hundred years, however, it could never match the popularity and relevance of the discounted cash flow (DCF) approach in the valuation practice. In the last few decades, residual income gained attention again. Studies examined its ability to explain stock prices, especially in comparison with the DCF model. The ambiguous results obtained give space for further research. In this study, we analyse panel data of 40 global manufacturing and service companies from the period 2013-2019. Our results indicate that the RIM is unable to match the DCF model in terms of explanatory power on stock prices, which is observable for both manufacturing and service firms. We also find that, with appropriate adjustments based on the Preinreich-Lücke theory, the DCF model's statistical relevance improves remarkably, although this improvement is more significant for service companies.

Suggested Citation

  • Andras Takacs & Edina C. Erb, 2021. "The residual income model cannot challenge the discounted cash flow method in stock valuations - an analysis of global manufacturing and service companies," International Journal of Sustainable Economy, Inderscience Enterprises Ltd, vol. 13(4), pages 323-335.
    • Handle: RePEc:ids:ijsuse:v:13:y:2021:i:4:p:323-335
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