An Accounting-Based Measure of Valuation Uncertainty
53 Pages Posted: 24 May 2021 Last revised: 22 Jul 2023
Date Written: July 22, 2023
Abstract
Existing measures of valuation uncertainty are indirect or available for limited samples. We use an accounting-based valuation model to estimate uncertainty as reflected in the shape of the distribution of intrinsic equity values. Our measure is effective in summarizing the information in existing proxies and offers substantial incremental variation. Among numerous possible applications, we test the hypothesis that valuation uncertainty is conducive to valuation mistakes. We show that a value-like long-short strategy is particularly profitable among high valuation uncertainty stocks. Stocks in the short leg earn average returns indistinguishable from the risk-free rate – turning negative following periods of high investor sentiment – and their future earnings disappoint. Insiders trade against the presumed valuation mistakes. Overall, our paper demonstrates how accounting information can be used to summarize uncertainty about intrinsic equity value.
Keywords: Valuation uncertainty, residual income valuation, valuation mistakes, value premium
JEL Classification: M41, G12, G14
Suggested Citation: Suggested Citation