On the Equivalence of Dividend, Free Cash Flow and Residual Income Valuation

From a theoretical point of view the three standard equity valuation approaches, i.e. the Dividend Discount Model (DDM), the Residual Income Model (RIM) and the Discounted Cash Flow Model (DCF) must yield identical equity values if ideal valuation conditions are given. However, under less than ideal conditions, practitioners as well as researchers report different value estimates, especially if dirty surplus accounting prevails or if payoff data for an infinite horizon are unavailable. As result, several recent studies (e.g. Penman/Sougiannis (1998), Francis/Olsson/Oswald (2000), Courteau/Kao/Richardson (2001)) find that RIM tends to outperform DCF and DDM. This paper demonstrates that even under less than ideal conditions identical value estimates can be achieved with the three models if they are properly adjusted. Within a comprehensive decomposition approach, we derive appropriate adjustment terms for the models in order to account for deviations from ideal conditions. Specifically, we derive adjustments for dirty surplus accounting, narrow dividend definitions, ne