Chartered Financial Analyst (CFA) Practice Exam Level 2

Which situation is best suited for a Residual Income model?

1. Firm has a strong dividend history

2. Expected free cash flows are positive

3. Firm lacks dividend history

4. Stable growth rate in earnings

The correct answer is: Firm lacks dividend history

The Residual Income model is particularly effective for valuing companies that do not pay dividends or do not have a reliable dividend policy in place. This model is based on the idea that the actual performance of a company can be captured by evaluating the profits generated over and above a required rate of return on equity capital. In situations where a firm lacks a dividend history, traditional valuation models such as the Dividend Discount Model are often inapplicable, as they rely heavily on expected future dividends to assess value. The Residual Income model, on the other hand, allows analysts to focus on net income and the capital required to sustain that income, making it suitable for firms that are reinvesting profits rather than distributing them to shareholders. Other scenarios, such as firms with a strong dividend history, expected positive free cash flows, or stable growth rates in earnings, are often better suited for alternative valuation approaches that emphasize dividends or cash flows directly, rather than focusing on residual income generated after covering the cost of equity. Thus, the lack of a dividend history positions the firm as an ideal candidate for the Residual Income model, which can provide a clearer picture of its intrinsic value.