‘Is Residual Income Model (RIM) Really Superior to Dividend Discount Model (DDM)?’ – A Misconception

Abstract

The development of the residual income model (RIM) has potential implications for the empirical researchers as the model specifies relationship between earnings and book values as proxies for equity values and accounting variables. Although researchers have supported RIM as an alternative to the dividend discount model (DDM), some empirical studies on RIM have triggered arguments on the superiority of the RIM over DDM. In theory, both models give the same value estimates; empirically, these value estimates changes with the changes in the assumption sets. In this paper, we show that both models provide the same values estimates when the terminal value can be forecasted. Although, under the perpetual growth rate model, the researchers have shown that empirically RIM outperforms DDM. We have shown that this superiority of RIM is misleading, as the transversality condition, a necessary assumption for deriving the RIM, is void under the perpetual growth rate scenario.