Residual Income Valuation: The Problems

Abstract

This paper identifies problems related to RIV in an equity valuation context. Three problems are discussed. First, on a per share basis clean surplus will not generally hold if there are expected changes in shares outstanding; this aspect eliminates a necessary condition for the RIV-formula to be valid. Second, an all equity approach does not work if the firm plans to bring in "new" shareholders who derive a net benefit from their capital contributions. Third, GAAP violates clean surplus because some capital contributions are not accounted for in market value terms. As an alternative to RIV, the paper shows that it makes more economic/accounting sense to focus on expected eps, adjusted for dps, as a valuation attribute instead of current book value and expected residual earnings.