EQUITY VALUATION USING ACCOUNTING NUMBERS

CASIRJ Volume 5 Issue 12 [Year - 2014] ISSN 2319 – 9202

International Research Journal of Commerce Arts and Science http://www.casirj.com Page 153

EQUITY VALUATION USING ACCOUNTING NUMBERS

NITIKA AGGARWAL Assistant Professor,

University of Delhi

Abstract

This research primarily focuses on the valuation methodologies used to value firms with high

and low intangibles as scaled by the total assets of the firm. In doing so a structured positive

approach is applied in all chapters to explain the outcomes. Various statistical tools and

databases have also been used to support the results and give them a strong base. Chapter two

gives a brief overview of valuation literature explaining the different valuation models in

practice. Chapter three deals with an exhaustive study of a small sample of twenty-one firms and

their analyst reports. Strict investigation of the analysts‟ reports reveal that Discounted Cash

Flow (DCF) model is the most commonly used valuation model across the firms of the sample.

However, multiples-based approach has also been used frequently, but DCF supersedes as the

dominant model in most of the cases. The analysis is extended to a large sample of 1140

observations in chapter four and involves empirical study to find out the valuation technique that

gives the most approximate estimate of price. The mean valuation errors are minimal for the

harmonic mean multiple after the REVM model. This analysis proves the better prediction

capability of the REVM model over the multiples model. Further, on running a sensitivity

analysis by varying the terminal growth rates and the number of observations in the sample it is

disclosed that larger the sample, greater the prediction accuracy. In addition to all of the above

the study adds to my skill and knowledge of equity valuation along with leaving some space for

further research for a more detailed set of hypothesis.

Chapter – 1:

Introduction

The aim of this dissertation is to understand the valuation techniques used in day-to-day pricing

of equities with the help of various statistical tools. This includes the financial statement analysis

of different companies along with studying the analyst reports to understand what valuation

models are used by the analysts. Moreover, the most interesting part of the report includes a

statistical study of two valuation methods to find out the prediction capability of both the models.



Therefore, this report consists of three well defined chapters which explain the objective of the

study along with producing valuable results of the analysis. In the first section, I do a detailed

literature review to introduce the various estimation methods used in the valuation history. This

involves the explanation of both the direct and flows based valuation methods including their

respective advantages and disadvantages. Some empirical evidence is also provided to support

the conceptual and the implementation issues faced by each of the models. The second and the

third section are driven by the motivation to study firms with and without intangibles. In the

second section a detailed study of analysts‟ reports of twenty-one firms reveal that analysts‟

prefer to use DCF as their dominant valuation model while pricing firms with high intangibles.

However, these results are hardly generalisable because of the small number of observations in

the sample. On an empirical analysis of a larger sample of 1140 firm year observations in the

third section, it is known that REVM is a better estimator of price than compared to harmonic

mean or median P/E multiple. This conclusion is based on mean and median testing of errors

between the valuation methodologies. The mean valuation error is lowest for the REVM price

estimates followed by harmonic mean P/E multiple. Estimates by the median P/E multiple has

the highest errors proving the superiority of the other practices. A further analysis conducted on

the firms with high and low intangibles separately produce the same results placing REVM as

the most superior model. A sensitivity test by varying the terminal growth rates and reducing the

number of observations in the sample still produce similar results. The mean absolute valuation

errors are the lowest for the REVM model. Hence, it will be true to state that REVM gives the

best estimates of price for intangible rich firms when compared with the multiples-based model.

Chapter – 2:

A critical review and synthesis of Valuation Literature

2.1Overview of Valuation Literature

Literature review is a critical analysis and synthesis of the academia relating to business

valuation using accounting numbers. Value is surrendered by the investors to the firm, the firm

adds or looses value and then the value left is returned to the investors. This is the simple cycle

of any business concern. The result of any business is expressed through financial statements.

The financial statements act as lens on the business and helps in determining the value of the

firm. Value of a firm can be defined as –

Value of a firm = Value of debt + Value of equity

The equity is the most important corporate claim, and the value of equity is the area of prime

focus for financial analysis. Accounting based valuation is the process of transforming forecasts

into an estimate of value of the firm. However, the obvious question here is the need and demand

for accounting based valuation. Investors may argue that a Company‟s value can be known

merely by looking at the share price. Nevertheless, under certain situations the share price is



typically insufficient in delivering the correct value of the Company. One such situation is when

a Company is not listed on any exchange yet still it needs to be valued when it is being

purchased by an investor or being listed on a stock exchange. This raises a question on the

efficiency of the stock markets, which is also proven by efficient market hypothesis. Market

efficiency does not imply that all stocks are always correctly priced. Therefore, the requirement

to value a company on the basis of intrinsic valuation is still very important.

Evidences of MM research indicate that earnings are the most important explanatory variable in

the valuation equation. In later times Graham, Dodd and Cottle have taken a similar position

with respect to valuation of common stocks. Nonetheless, the usefulness of accounting numbers

and earnings being a source of useful information has always been a topic of measurement

controversies in the accounting history.

Analytical tools and rigorously developed arguments have been the base for the accounting

theorists in the past to evaluate the usefulness of accounting numbers. However, the results

obtained prove to be unworthy without proper comparison of the observed behaviour with the

predictions of the model. Ball and Brown (1967) investigated what the market expects income to

be and then the markets reactions when its expectations prove false.

As against the above claims, there are many strong evidences against the belief that earnings

have informational value two of which are - measurement errors through earnings are large and

there are other sources that give the same information more timely than earnings.But, on price

and volume analysis, it is quite evident that investors do look at the earnings announcements

instead of other variables to price stocks and change their stock holding preferences accordingly.

A study by Ball and Brown in 1967 found that economy wide effects explain close to half of the

variability in the level of a firm‟s EPS. The firm‟s financing and other policy decisions explain

the other half.

Modelling the valuation strategy of any Company involves a lot of start up hiccups. Some of

those could be the duration of earnings to be considered, forecasting of earnings or other

variables, selection of valuation model suited to the Company‟s financial data etc. Valuation can

be conducted from two perspectives – i) Equity (proprietary) view & ii) Entity (enterprise) view.

Unlike the entity perspective, equity perspective distinguishes between capitals provided by

different sources and hence often outweighs the other because of the weight age given to equity

investment. Financial theory defines firm value as the present value of expected future pay offs.

Though a firm can be valued from either perspective the basic difference lies in the present value

calculation. Under equity perspective, firm value equals the present value of expected future

dividends while present value of expected free cash flows gives firm value according to entity

perspective.



2.2Theoretical Framework of Equity Valuation

Identifying the correct valuation model is what makes a good analyst. This involves trading off

cost and complexity because analysts often avoid complex models that require extensive analysis

involving a lot of costs and thus may ignore important value drivers. Today in the industry there

exists, many valuation models to price a company. Some of them worth mentioning are - The

Multiples-based Valuation Model, Discounted Cash Flow Model (which is the theoretically the

most sound model), The Dividend Discount Model, The Residual Income Model and the

Residual Income Growth Model.

2.2.1Multiples-based Valuation Model

Methodology - A multiple can simply be defined as the ratio of the stock price to a particular

value driver in the financial statements. Various value drivers like earnings, book value, sales,

EBIT, EBITDA have been used for valuing equity but earnings is the most commonly used value

driver in financial history. The methodology involves the selection of a set of comparable firms

that could be either all firms, firms from the same industry, firm with similar characteristics etc.

to the target firm whose value is in question. These set of firms are used to identify measures to

calculate benchmark multiples at which the firm trades. The average or median of these

multiples is then applied to the value driver of the target firm to get the intrinsic value of the

firm.

The general method for pricing multiples can be written as:

j

j

iiiVD

PjaverageVDV

where:

iV = estimated value of firm i

iVD = value driver of firm I, where VD > 0

jP = observed price for the jth

firm

i = set of comparable firms (j = 1to n) for firm i

The success of Multiples-based valuation approach relies on some underlying assumptions:

(Young-Soo Choi, 2007)

- Comparable firms have future cash flow expectations proportional to the target firm whose

value is in question.



- Comparable firms face similar risks to those of the target firm

- The value driver is directly proportional to value.

Though working with these assumptions the Multiples-based approach can produce most

accurate value estimates than any other valuation methodology, but these assumptions are often

desecrated. „Comparable firms are not perfect matches to the target firm in terms of cash flowor

risks, and even the valuation history does not suggest any obvious way to select the best value

drivers.‟ (Young-Soo Choi, 2007)

Advantages & Disadvantages – The advantage to use the Multiples-based approach is that it is

the cheapest form of valuation methodology. It doesn‟t require multi year forecasts of parameters

and uses nominal information from the financial statements. Hence, the technique does not

require professional accounting knowledge. Therefore, the method leaves too much room for

“playing with mirrors.” The analysts have the freedom to obtain a valuation, as he/she desires

because of the usage of minimal information that leads to speculation. Analysts using this

methodology may at times end up misvaluing an entire sector.

Conceptual &Implementation Issues – Despite its apparent simplicity, Multiples-based

approach suffers from some conceptual and implementation issues. Conceptually this approach

faces the problem of circular reasoning since price is ascertained from price of the comparables

and hence violates the principle by involving price in the calculation. Market is assumed to be

efficient for comparable firms but not for the target firm which is also a conceptual issue.

Moreover, considering the inefficiency of the markets, the comparable firms may be mispriced

which may generate faulty valuations for the target company. In addition, fundamentally while

valuing the firm we are estimating the value that investors are willing to pay instead of the

intrinsic value of the firm.

Apart from these conceptual problems, there are some relatively complex technical hitches as

well:

1) Choice of the Value Driver – Earnings is the most commonly used value driver because it

uses accrual accounting and overcomes the timing and mismatching problems inherent in

cash flows. Current earnings are preferred over current cash flows to predict dependable

future cash flow numbers. The high correlation between earnings and stock returns (rather

than cash flows) measured over short time periods was established and demonstrated by

Dechow (1994). But, at times earnings may be negative or close to zero rendering very high

or undefined P/E multiples. Thus earnings may be a poor measure of value creation as in the

case of internet firms where earnings may be negative or zero for a long period of time. This

mean reversion in P/E ratios over time may also result due to the presence of transitory

components in earnings as concluded by Beaver and Morse (1978).



Moreover, various definitions of earnings (earnings before/after abnormal items, earnings

before goodwill amortisation, earnings before interest, tax and depreciation, etc.) might also

create confusion for its appropriateness to be used for valuation purposes. Analysts and

investors try to condense this impact of transitory components by using adjusted earnings

figures. But, adjusted earnings are defined differently not only across borders and databases

but also differ from firm to firm and analyst to analyst. Apart from these the mixtures of

numerator & denominator combinations in a multiple also face implementation problems.

They should be comparable in the sense that with equity value (share price) in the numerator,

the denominator should also be an equity level value driver (net income) and with sales as the

denominator, the numerator should be an entity value (debt plus equity). But, in situations

like valuing hi-tech or internet firms (where income is often negative) a fusion of value

drivers (sales with share price) sometimes makes sense.

Liu, Nissim and Thomas (2002) after examining a comprehensive list of value drivers

conclude that forward earnings explain stock prices better than historical earnings and cash

flow measures. Lev (1983) in his study examined the link between industry characteristics

and P/E multiples. Liu, Nissim and Thomas (2003) tested the performance of multiples

(value drivers – earnings, operating cash flows, sales & dividends) across different countries

and arrived at similar recommendations. Lie and Lie (2002) concluded that forecasted

earnings perform better than trailing earnings but asset value multiples yield better estimates

than sales or earnings multiples especially for financial companies because they have

substantial liquid assets that are easier to value. They also found that EBITDA performs

better than EBIT multiple except for pharmaceutical companies. While valuing IPO‟s Kim

and Ritter (1999) found that P/E multiples using earnings forecasts instead of historical

numbers improved the valuation precision sustainability considerably for older firms. Tasker

(1998) in her research on industry specific preferred multiples in acquisition valuation reveal

that banking industry is valued on book and net income multiples, software targets on

revenue while hotel, oil and real estate industries on operating cash flow multiples. However,

a possibility of other accounting numbers being highly correlated with firm value was left for

future research. Fernandez (2002) finds that because of broad dispersions in multiples the

valuations are always debatable. He also finds that PER, EBITDA and profit after tax were

more volatile parameters than equity value during 1991-1999.

2) Comparable Firms Selection – Under the approach, multiple can be computed for a single

comparable firm. It is advantageous since it is easier to identify a single firm similar to the

target firm in respect of growth and risk parameters. Multiples can also be computed for a set

of comparable firms since in a set the firm specific differences tend to cancel out leaving the

average effects only. Under such a case analysts tend to focus on firms in the same industry

that are more likely to be affected by the same broad set of factors. Nonetheless, this requires

thorough knowledge of the industry, market and firm specific parameters. Most of the firms



today operate in multiple industries and hence cause difficulties in identifying comparable

industry. Moreover, concerning a profitable deal, analysts tend to influence the valuations by

selecting comparables with high multiples. Alford‟s (1992) generalised results propose that

industry membership [which is similar to Liu, Nissim and Thomas (2003)] or a combination

of risk and earnings growth is effective criteria for the selection of comparable firms. Bhojraj

and Lee (2002) find that selecting firms based on profitability, growth and risk criteria offer

sharp estimate improvements over selection based on industry and size matches. Their

experimental evidence suggests analysts to focus on more salient firms within an industry

while selecting comparables.

3) Multiple Computation – Using mean multiple for the comparable firms is the most obvious

approach but due to the presence of largely skewed accounting variables it may be largely

influenced by extreme observations. To avoid this problem, other ways like trimming the

outliers, using median/weighted average/ harmonic mean have also been considered.

n

j j

j

VD

P

nMean

1

1 ,

n

j j

j

P

VD

n

MeanHarmonic

1

1

1

Out of the above harmonic mean diminishes the effect of small denominator problems and

yields less upward-biased value estimates and hence is preferred over the others. Alford

(1992) supported the use of median multiple to avoid the effects of extreme outliers. Liu,

Nissim and Thomas (2003) use harmonic mean to estimate the appropriate multiple to

improve efficiency by making errors proportional to price. They exclude cases having

negative value drivers, which might have resulted in better estimates but rightly exclude the

firm to be valued while computing the multiple.

4) Different accounting methods used for the comparables and the target firm also poses a big

implementation problem.

5) Multiples may be affected by leverage effects for which some entity level ratios (Unlevered

price/EBIT, Unlevered price/sales ratio) are suggested that remain unaffected by leverage.

Alford (1992) found a diminishing accuracy when multiples were adjusted for leverage.

2.2.2. The Dividend Discount Model (DDM)

Methodology – Forecasting is at the heart of the process of fundamental analysis and a valuation

model specifies what is to be forecasted and further how it is converted to a valuation.

Accounting flows-based valuation approach is to estimate the intrinsic value of a firm by

discounting forecasted future accounting flows. Dividends are the cash flows that shareholders

get from the firm. Therefore, DDM involves forecasting future dividends and discounting by the

cost of equity to give the present value at the valuation date.



1 1

e

tte

tk

DIVEV

where:

e

tV = equity value at time t

tE = expected value at time t

tDIV = net dividend at time t

ek = cost of equity capital

Under assumptions of zero dividend growth, valuation formula becomes short and simple,

e

te

tk

DIVV 1

To be practical forecasted numbers should be observable ex-post and information gathering &

analysis should be straightforward with fewer pieces of information. While forecasting we can

look upon equity, financing and operating activities that can create value. Yet, our focus is on

operating activities since they are most important in determining the value of a firm.

However, forecasting dividends to infinity is impracticable. For that reason, valuation models

involving forecasting of flows comprise of a finite horizon and a terminal value term. This

terminal value can be looked upon as the „price‟ at which we might sell the operating entity at

the forecast horizon. The terminal value is the value of perpetuity, calculated by capitalising the

forecasted dividend at T+1at the cost of capital. There can be less than full payout of earnings

and dividends may grow as the retained funds earn more for the firm. This idea can be

accommodated in a terminal value calculation that incorporates growth –

Te

de

TT

e

tte

t kgk

DIV

k

DIVEV

11

1

1

where:

T = finite forecast horizon

dg = dividend growth rate after time T



If the constant growth starts in the first period, it is sometimes referred to as The Gordon growth

Model.

Advantages, Disadvantages & Implementation issues – The only advantage with the DDM is

that the concept is simple and is easy to forecast dividends in the short run considering its

stability. Nonetheless, solutions to problems like valuing a firm that may be expected to have

zero payout or a firm that has exceptionally high payout that cannot be maintained or dividend

payout coming from borrowings or stock repurchases have not been justified in valuation history.

This way dividend policy can be any arbitrary value not linked to value addition. Hence,

dividends may not always represent creation of wealth. Paying dividends is termed as a zero-

NPV activity, since any change in dividends is exactly offset by a price change in present value

terms, in a manner such that net effect is zero. This leaves us with a problem of dividend

conundrum where forecasting dividends does not give an indication of value creation. Rather,

they represent distribution of value.

2.2.3. The Discounted Cash Flow Model (DCF)

Methodology – Failure of DDM in fundamental analysis leads us to DCF and forecast

something that is tied to creation of wealth. Free cash flow (FCF) is the amount of cash that the

operating entity of a firm pays or receives from the pool of net financial assets of the firm. It is

expressed as net of tax cash flows arising from the operating activities1 of the firm. „In a

particular year, the difference between the cash flow from operations and outlays from new

investment is called the FCF, because it is the part of the cash from operations that is „free‟ after

the firm re-invests in new assets.‟ (Penman, 2007).

dttt CICFCF

where:

tFCF = Free cash flow at time t

tC = operating cash flow at time t

tI = net new investments at time t

dC = net cash flow from debt holders

Hence, the firm‟s operations can be valued using the present value formula:

1 Operating activities according to the definition in DCF is the value of operating activities of the firm with investing

activities implicit in operations.



1 1

WACC

FCFEEV tt

t

where:

tEV = enterprise value at time t

WACC = Weighted Average Cost of Capital

The discount rate used in this model is different from DDM and is called the Weighted Average

Cost of Capital (WACC) or the Cost of Capital from Operations. Moreover, since the equity and

debt claimants have to share the payoffs the value of the equity is the firm‟s value less the value

of net debt.

d

tt

e

t VEVV

where:

e

tV = value of equity at time t

d

tV = value of debt at time t

It is noticeable that like the DDM this model also forecasts over an infinite horizon. For a

forecast of value up to a finite horizon, a continuing value term (value of free cash flows after the

horizon) has to be added. This continuing value term is not similar to the terminal value of

DDM. Unlike the terminal value, the continuing value term gives us the value omitted by the

calculation when we forecast up to a finite horizon rather than to infinity. Yet again, these cash

flows after the finite horizon may follow a trend unknown to us. We can proceed in a way

similar to the DDM forecasting FCF as a flat or a growing perpetuity.

T

f

TT

ttt WACC

gWACC

FCF

WACC

FCFEEV

11

1

1

where:

fg = growth rate of FCF

Advantages & disadvantages –Cash flows are real, easy to think about and not effected by

accounting rules. Moreover, because of its straight application of familiar NPV techniques, it is

an easy and advantageous concept to use. Nevertheless, on the other hand DCF negates the

matching principle, fails to recognise value generated where cash flows are not involved and



reduces investments (treated as a value loss) from operations, which actually adds value to the

firm. Additionally DCF demands long forecast horizons to recognise cash inflows from

investments and is not aligned with analyst‟s forecasts who estimate earnings instead of FCF that

requires further forecasting of accruals.

Implementation Issues – DCF works best when investment pattern produces constant FCF or

FCF growing at a constant rate, which is rarely observable. Apart from this, DCF application

faces two more problems. Firstly, the US-GAAP net cash figure needs to be adjusted with

interest received/paid figures using information provided in the notes to financial statements and

secondly it needs to be adjusted with the financial investments figure since it does not form a

part of FCF generated by operating entity. Demirakos, Strong and Walker‟s (2004) findings

show that analysts typically use DCF as their dominant valuation model. Copeland et al. (2000)

assert that DCF is most widely used but REVM is gaining popularity.

2.2.4. The Residual Earnings Valuation Model (REVM)

Methodology – Residual earnings/Residual Income (RE/RI) also known as abnormal earnings is

earnings in excess of a normal return on capital employed. The term Economic Value Added

(EVA) patented by Stern Stewart, a consulting firm as a special case of measure in performance

measurement is also used synonymously. RE can be calculated as net income less a capital

charge on the opening book value of equity under equity perspective and as net operating profit

after tax less a capital charge on the total capital employed under entity perspective.

1 tet

e

t BVEkNIRI

1

tt

de

t NAWACCNOPATRI

where:

e

tRI = Residual Income under equity perspective

tNI = Net Income at time t

1tBVE = Book Value of equity at time t-1

de

tRI = Residual Income under entity perspective

tNOPAT = Net Operating Profit after Tax at time t

1tNA = Net Assets at time t-1



The fundamental expression for the value of equity (under Clear Surplus Relationship

assumptions) in terms of the present value of expected dividends and free cash flows is used to

derive the REVM.

Equity Perspective -

1 1

e

te

tt

e

tk

RIEBVEV

Entity Perspective -

1 1

WACC

RIENAEV

tde

ttt

Primarily under equity perspective applications of REVM, the valuation method involves

observation of accounting book value of equity along with forecasting of RI and calculation of

their present value. If a firm is expected to earn its normal rate of return then the intrinsic value

equals the book value, but earns a premium if the return exceeds the normal rate. Hence,

considering a finite horizon REVM comprises of the anchor (book value) and a premium over

book value. However, a continuing value term is added to incorporate the RE over an infinite

horizon and is represented as a growing perpetuity at rate RIg –

Te

RIe

Te

e

te

tt

e

t kgk

RI

k

RIEBVEV

11

1

1

where:

T = finite forecast horizon

RIg = Residual Income growth rate after time T

According to clear surplus relationship (CSR) all changes in the balance sheet value of owners‟

funds other than transactions with owners are included in earnings. If the forecast of dividends,

book values and earnings are consistent with the CSR, the REVM should give the same estimate

of intrinsic value as given by the DDM. However, inconsistent assumptions like a constant rate

of dividend growth after time timplies a constant rate of growth in RE after time t,may give

different value estimates. Like equities, a single project or an operating entity can also be valued

using a formulation of REVM.

Advantages & disadvantages – The REVM is a preferred form of valuation method firstly

because given CSR, it implies the independence of firm value from accounting procedures.

Moreover, it focuses on profitability and growth in investments (treats as an asset rather than

cost) as a value driver, makes use of the numbers appearing in the financial statements (the book

value), uses properties of accrual accounting and follows the matching principle. It is aligned



with the analyst‟s forecast of earnings rather than FCF or dividends along with its validation in

subsequent audited financial statements and can consider shorter forecast horizons as compared

to DDM and DCF. Nonetheless, people using this method require thorough understanding of

accrual accounting so that causes of concern can be identified.

Implementation issues –

1) Forecasting of RI requires forecasted future earnings that may vary in numbers and

reliability in terms of the sources used. I/B/E/S data is available for one or two year ahead

and are unsuitable for a long forecast horizon. Moreover, future book values are not available

and the analysts have to compute their own forecasts. This requires estimation of dividend

payout ratio (dpayout), which eventually complicates when earnings are negative. Solutions

to the above are trimming negative observations & introducing a sample selection bias or

replacing them by estimated long-run earnings performance. An alternative solution when

dividends are greater than earnings is to set dpayout = 1. Using the ratio (V/P) Frankel and

Lee (1998) show that REVM is a consistent estimator of cross-sectional returns (using

forecasted instead of historical earnings) particularly over longer horizons. They also found

that V/P‟s projecting power improves by incorporating errors in analysts‟ earnings forecasts

that are predictable.

2) Estimating Terminal Value (TV) – TV often forms a large proportion of the total firm

value but there is no set way for its calculation. Often varied approaches are used which

range from relatively simple to moderately complex.

3) Estimating the cost of equity capital – This estimation requires researchers to measure i)

The risk free rate ii) Beta for the firm & iii) Market risk premium. All these three measures

are difficult to estimate and have always been a subject of debate by analysts and academics.

Francis, Olsson and Oswald (2000) in their reliability study of intrinsic value estimates find that

RE value estimates are more accurate and explain greater variations in prices than DDM or DCF

value estimates. Penman and Sougiannis (1998) do a similar comparison with usage of ex-post

forecasts instead of ex-ante forecasts as the primary difference. The superior accuracy of RE and

inclusion of book value of equity as a measure of intrinsic value steer the greater dependability

of RE value estimates. In addition, there was no evidence of inferior estimates of equity value

due to different accounting practices. Lee, Myers and Swaminathan (1999), aim to develop

measures of the intrinsic value for the Dow Jones Industrial Average (DJIA) independent of its

market price. They find that V/P ratio (where V is based on a REVM) outperforms traditional

value benchmarks like B/P, E/P in terms of both tracking ability and predictive power during the

1963-1996 period and inclusion of time varying interest rates contributes primarily towards its

success.

However, Lundholm and Keefe (2001) argue that if properly implemented, DCF and REVM

yield similar value estimates and try to explain the minor errors, which cause inconsistencies.

These inconsistencies generally arise because of faulty forecasts at the start of the terminal



period, variations between the cost of equity and the WACC or missing cash flows in one or both

the models, which were discarded by Penman (2001). Sougiannis and Yaekura (2001) find that

analysts‟ earnings forecasts convey more information than given by current earnings, book

values and dividends at each horizon and that different valuation models are appropriate to

different firms under given conditions. They also conclude that the huge differences between

market price and observed price are due to conservative accounting and missing information in

the forecasts. Ohlson and Nauroth‟s (2005) model assumes that the PV of dividend per share

(dps) determines price without restricting the expected evolution of dps-sequence.

2.2.5. The Abnormal Earnings Growth Model (AEGM)

Methodology – Earnings, whose growth validates a high P/E ratio as well, primarily influences

the P/E ratio. An investor might be paying too much for earnings growth, but growth through

investment does not necessarily mean a value addition. Hence, a valuation model is required that

prevents investors from paying too much for earnings growth. AEGM states the relationship

between price, forward earnings and abnormal earnings growth. The AEGM anchors the

valuation on capitalised earnings and then adds value from anticipated growth. Here, AEGt

(Abnormal Earnings Growthat time t) can be expressed as an excess of periodic earnings change

over a normal return on previous period retained earnings–

][ 111 ttettt DIVNIkNINIAEG

Considering CSR relationship the equity value can be presented by a simple equation–

1

1

1

ee

tt

e

te

tkk

AEGE

k

NIV

The equity value with a continuing value term can be derived from the model using the equation

–

Tee

e

T

ee

tt

e

te

t kkgk

AEG

kk

AEGE

k

NIV

11

2

1

An important point to note here is that, if accounting obeys the CSR, AEG is equal to the first

difference of RE. In addition, if the RE is assumed to grow at a constant rate after time T +

1,AEG can be assumed to grow at the same constant rate after time T + 2.

Advantages & disadvantages – The analysts forecast earnings, earnings growth, and the AEGM

focuses directly on the most common multiple in use, the P/E ratio. Hence, it is easy to

understand and is aligned with what people forecast. AEGM uses the properties of accrual

accounting and the matching principle and can be used under a variety of accounting principles.



Nevertheless, AEGM is a complex model and requires a through understanding of the concept of

cum-dividend earnings along with accrual accounting. Moreover, since it does not focus on

Balance Sheet items and all values are derived from forecasts, the valuation is extremely

sensitive to the estimates. In such a case, the earnings numbers might be a suspect and may give

erroneous estimates of equity value.

Ohlson (2005) position AEGM as a better estimator than REVM because it does not rely on book

values and CSR accounting and focuses on ex-ante earnings as a better estimator of market value

than book value.

2.3 Summary

This chapter introduces the theoretical framework of equity valuation along with discussions on

empirical studies of each model by referring to research papers. Even though direct valuation

models (REVM, AEGM) have been preferred over relative valuation model, some fundamental

problems with them are, computing the value of „synergies‟ of assets being used together,

identifying value in use of a particular firm, valuing loss-making firms or firms in financial

distress etc. Lie & Lie (2002) in their study find valuation estimates to be worse for companies

with high intangibles specially the dot-coms. In addition, direct valuation approach face

complications in calculating the liquidation value and value estimates of asset based firms like

oil and gas. Although there is not much evidence in the prior research to support the comparison

of direct and relative valuation approaches, on extensive analysis with a large sample Courteau,

Kao, Keefe & Richardson (2006) found that a simple combination of the two yield better

estimates of intrinsic value than either method used in isolation.

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EQUITY VALUATION USING ACCOUNTING NUMBERS