Corporate Valuation: An Empirical Comparison of Discounting Methods

65 Pages Posted: 24 Apr 2021 Last revised: 23 Jan 2023

See all articles by Nicolas Hommel

Nicolas Hommel

Princeton University

Augustin Landier

HEC

David Thesmar

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Date Written: April 16, 2021

Abstract

The key purpose of corporate finance is to provide methods to compute the value of projects. The baseline textbook recommendation is to use the Present Value (PV) formula of expected cash flows, with a discount rate based on the CAPM. In this paper, we ask what is, empirically, the best discounting method. To do this, we study listed firms, whose actual prices and expected cash flows can be observed. We compare different discounting approaches on their ability to predict actual market prices. We find that discounting based on expected returns (such as variants on the CAPM or multi-factor model), performs very poorly. Discounting with an Implied Cost of Capital (ICC), imputed from comparable firms, obtains much better results. In terms of pricing methods, significant, but small, improvements can be obtained by allowing, in a simple and actionable way, for a more flexible term structure of expected returns. We benchmark all of our results with flexible, purely statistical models of prices based on Random Forest algorithms. These models do barely better than NPV-based methods. Finally, we show that under standard assumptions about the production function, the value loss from using the CAPM can be sizable, of the order of 10%.

Keywords: Valuation, Present Value Formula, ICC

JEL Classification: G31, G32

Suggested Citation

Hommel, Nicolas and Landier, Augustin and Thesmar, David, Corporate Valuation: An Empirical Comparison of Discounting Methods (April 16, 2021). Available at SSRN: https://ssrn.com/abstract=3827511 or http://dx.doi.org/10.2139/ssrn.3827511

Nicolas Hommel

Princeton University ( email )

United States

Augustin Landier

HEC ( email )

France
+33630006051 (Phone)

HOME PAGE: http://https://sites.google.com/site/augustinlandier/

David Thesmar (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
Cambridge, MA 02142
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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