A Swan Song for the Value Driver Model-Modern Theory and Application of Constant-Growth Equity Valuation Models

Abstract:     
In this paper we shed new light on the most widely used terminal valuation tool: the accounting based value driver model (VDM). Based on a purely cash flow-driven approach we identify the requirements necessary for proper application of the VDM under a conservative accounting regime and show that, contrary to pure cash based models, the VDM only works accurately in an aseptic academic environment. A scenario analysis emphasises the noticeable quantitative impact of any violations of these assumptions. Artificially adjusting real world figures to the required aseptic academic environment is principally possible but entails additional workload and bloats the valuation model. We further show that the VDM is not only a fragile valuation tool from a technical/theoretical perspective but also prone to be misused in valuation practice due to its reliance on book rates of return rather than economic rates of return. The paper contributes to the current literature on accounting based equity valuation in various ways, as it shows that the original Gordon/Shapiro (1956)-model is misspecified as long the accounting system exhibits the characteristics of conservativeness, it lends fresh support to the Ritter/Warr (2002) critique of residual income valuation models, it highlights new problems of accounting based valuation models and it introduces new practice-relevant aspects into the discussion about terminal value estimates between Penman/Sougiannis (1998) and Lundholm/O’Keefe (2001 and 2001a). This paper stands for a renunciation of the VDM as well as an embracement of purely cash driven models.

Number of Pages in PDF File: 70

Keywords: value driver model, equity valuation, terminal value, accounting based valuation

JEL Classification: G12, G30, M49

working papers series