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In theory, given predictions of payoffs to infinity, all valuation methods are supposed
to provide a similar prediction of value. However, due to impracticalities with
forecasting an infinite stream of fundamentals, analysts use simplifying assumptions
especially in the LR and make detailed forecasts only for a limited horizon.
To get some inferences on the quality of each valuation methodologies, we need to
compare them based on their achievement of objectives. Valuation objectives are:
i)
ii)
Thus, the quality of each valuation methods can be judged based on which methods
best explains share prices and which has the most predictive power with respect to
future returns.
1a. A comparison of dividend, cash flow and earnings approach to equity
valuation (Penman and Sougiannis, 1998)
Research topic:
Dividend, FCF and AE are equivalent when respective payoffs are forecasted to
infinity. However, in practice forecasts are made over finite horizons.
Penman and Sougiannis (1998), through their research, aimed to:
i)
ii)
Compare the value estimated by DIV, FCF and AE in finite horizon using
actual realizations as proxies for expected values to assess accuracy of
forecast methods.
Identify which method work best for different finite horizons eg. Over 1
year, 2, 5 or 8?
Assumptions:
Ex-post realisations are equal to ex-ante rational expectations and that markets are
efficient. Valuations are calculated with or without CV to account for value of firm
after T.
Methodology:
Accuracy of valuation methods is assessed by comparing actual prices against ex-post
payoffs prescribed by the model (inputs are ex-post accounting realizations).
Valuation errors per unit of price at t are calculated as:
Assumptions:
Three different assumptions are used for terminal value:
-
Francis et al. (1997) use Value Line annual forecasts of the payoffs in these models to
calculate value estimates thus their empirical evidence is based on forecast (not
realised) proxies of the payoffs
Methodology:
-
Results:
As regards accuracy, the empirical evidence (adapted in Table 8.10) shows:
- The most accurate value estimates also explain the most variation in
contemporaneously observed prices
- Terminal value based on Value Line 35 year ahead P/E forecast: