The value investor does not ignore formulas but sees them as a way of thinking and asks: It that a good way of thinking? Is it practical? And, of course, she or he asks if the formula is based on good assumptions. Asking these questions of the Dividend Discount Model and the Discounted Cash Flow Model yields a NO to one or more of these questions, as Chapter 3 explains.
The most important question is whether the model is a good way of thinking. If so, the investor embraces the model, not as a formula to plug into but to guide thinking and ultimately valuation and analysis. The residual earnings model is an example. The two assumptions underlying it are palatable. First, investors invest to get dividends: quite reasonable. Second, the clean-surplus equation by which successive book values increase with earnings and are reduced by dividends: That’s how accounting actually works! And the thinking of the model makes sense: Firms invest and that investment is (usually) recorded on the balance sheet. Firms apply the invested assets to generate earnings. So value is added to the balance sheet with earnings but only if those earnings cover the required return on the investment.
But that’s not the end of it. The model requires estimates of the hurdle rate (required return) and a long-term growth rate. And it requires good accounting that captures value added. There is much to be done to take the thinking in the model to actual practical investing. That is what the book does as it proceeds. Chapter 4 finesses some of these difficulties.