A Sum & Discount Method of Appraising Firms: An Illustrative Example

Abstract

Abstract. This paper presents a new way of valuing firms and measuring residual income. The method, originally introduced in Magni (2000aMagni ( , 2000bMagni ( , 2000cMagni ( , 2001, is here renamed lost-capital paradigm. In order to enhance comprehension the presentation relies on a very simple numerical example which shows that the new paradigm of residual income enjoys a property of abnormal earnings aggregation, according to which the NPV (and therefore the market value) of the firm does not change if each residual income changes, as long as the (uncapitalized) sum of all residual incomes do not change. While radically different from the standard residual income, the difference between the two notions is equal to the interest accrued on the past cumulated standard residual incomes, which has interesting implications for incentive compensation.

Splitting up value: A critical review of residual income theories

“…Thus, errors in timing are neutralized. In contrast, in the standard paradigm one finds, in general, that the forecasted value differs from the correct value if residual incomes are incorrectly attributed to periods: Magni, 2007c). This implies that the heuristic of the arithmetic mean ( n t=1 Π e t )/n of expected residual incomes for forecasting purposes is highly relevant in this context (see also Remark 1 below).…”