If you're an analyst involved in M&A activity or just interested in valuing stocks, you might have seen a flyer recently that announced a one-day seminar on a new way to value companies. It's called the Residual Income Valuation Model–RIM, for short. According to the flyer, the model is “the talk of Wall Street” and should be considered by readers a “breakthrough” in valuation. In fact, the ad suggests that the model takes the guesswork out of valuation. “Traditionally, valuation has been more of an art than a science,” it reads. “It is difficult to quantify or rationalize art. Analysts need a logical framework for valuation that they can defend in both theory and practice. RIM is that framework.”
But is it? That is hard to say. The classical way to value a company–other than through measures such as P/E ratios, which are used to compare one company with another–is the discounted cash flow model, or DCF. The valuator estimates future cash flows of the company and discounts those cash flows to present value; the result is a “number” on the company. The approach makes sense. Cash flows give a company its value–which is what you're looking for when you're doing a valuation, after all–so measuring them seems to be an obvious way to get a handle on what a share in the company is worth. The problem with DCF, though, is that it often doesn't take into account forms of value that aren't reflected in cash flows.
As a basic example, let's assume that Company A invested in a $1-billion plant. The money Company A used to pay for the plant would be spent now, reducing immediate cash flow, and that would mean the value in that plant will be realized years later when cash flows rise again. “You would have to estimate cash flows far into the future to get the value of that plant,” says Dan Thornton, a Queen's School of Business financial accounting professor who is teaching the seminar on RIM.
By contrast, Thornton explains, the residual income model will immediately capture the cost of the plant in book value. Any additional economic value of the plant will be contained in future residual income. Rather than look at cash flows, the valuator, working from estimates of earnings, calculates how much economic value there is in a company beyond the cost of equity capital. Anything beyond that adds to value. Think of it as measuring the accounting concept known as goodwill, that intangible that often plugs the difference between the book value of a company and what it actually sells for.
Many accounting students are familiar with a valuation approach called Economic Value Added, or EVA–a copyrighted term for a valuation approach that is similar to the RIM model. EVA has been around as a term for several years (as have RIM models), but according to Thornton these approaches are much more common in the United States. “At the University of Michigan, they teach 10 sections in this,” he says. “I would be lucky if half of my MBA students have heard of it.” (That's why he's offering the one-day seminar.)
The hitch in the RIM model is that you have to estimate earnings into the future, which means you have to rely on analysts. That, says forensic accountant Al Rosen, of Rosen & Associates Ltd., is a flaw. “You have to believe in perfect numbers from analysts,” he says. “And I don't know many that do.” For his part, Thornton points out that those who come up with estimates of earnings have reputational capital on the table, so they have a vested interest in getting it right, while cash flows are often derived internally by companies and are therefore hard to estimate. That, he says, gives the edge to RIM over DCF.
Perhaps one should defer to Jerry Feltham, a professor of accounting at the Sauder School of Business at UBC (and an esteemed member of the Accounting Hall of Fame), on this question. Feltham was one of the original academic thinkers behind RIM–it's also known as the Feltham-Ohlson model, for the work Feltham did with Jim Ohlson in the early '90s. “It's another way of looking at a company–it's an alternative,” says Feltham from the West Coast. “To get the best answer, you would use a variety of approaches.”
