I ran across a question on advantages to Residual Income Models that stated choose the statement that is correct. The correct answer said “Residual Income models do not require forecasting future earnings.” I dont see how this can be since RI= Net Income - Equity Charge. You have to forecast NI.
However, you can just use (ROE-Ke) * Book Value to project Residual Income. Is this what they are referring to? I still feel that, in either case, you are forecasting earning power of the firm. I guess it’s just not forecasting out each line item if you just made an assumption about ROE. Is that what they are getting at?
Pretty wordy way to put it, but you do not require to forecast earnings, that’s true.
You need to forecast ROE and reinvestment rate, whether for single stage or multi-period horizon. It’s far from the best method to value a company, but it’s legitamite in theory.
Thanks. Still seems like you are making forecasts/assumptions about the earnings of the firm with ROE - i guess you do avoid forecasting COGS, Depreciation, etc. I guess it’s more of you are making an assumption/forecast of return of the firms equity rather than actual NI.
If it’s a stable firm, take the 5-year average ROE, to adjust for cyclicality, and you’re good to go.
If it’s a growing firm, do a 2 stage H-model with the ROE declining close to the Ke, on a number of years as you see competitive advantage fit. The equation doesn’t need “Earnings” if done in a gordon growth model. I remember being fooled by that in my L2 reviews last year.