Question #14
Reading: Reading 23 Residual Income Valuation
PDF File: Reading 23 Residual Income Valuation.pdf
Page: 7
Status: Correct
Correct Answer: A
Question
Analyst Brett Melton, CFA, is looking at two companies. Happy Cow Dairies has volatile cash flows, and its free cash flow is often negative. The company pays no dividends. Glitter and Gold, a maker of girls' clothing, has a fairly steady stream of earnings and cash flows but takes a lot of charges against equity. Is the residual income model suitable for valuing the two companies? Happy Cow Dairies Glitter and Gold
Answer Choices:
A. No No
B. No Yes
C. Yes No
Explanation
Residual income models work for companies with no dividends and volatile or negative
cash flows. They do not work, however, when the clean surplus relation does not hold, as
is the case when companies take charges against equity.