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A Comparison of Dividend, Cash Flow, and Earnings Approaches to Equity Valuation

68 Pages Posted: 31 Mar 1997  

Stephen H. Penman

Columbia Business School - Department of Accounting

Theodore Sougiannis

University of Illinois at Urbana-Champaign - Department of Accountancy

Abstract

Standard formulas for valuing the equity of going concerns require prediction of payoffs "to infinity" but practical analysis requires that they be predicted over finite horizons. This truncation inevitably involves (often troublesome) "terminal value" calculations. This paper contrasts dividend discount techniques, discounted cash flow analysis, and techniques based on accrual earnings when applied to a finite-horizon valuation. Valuations based on average ex-post payoffs over various horizons, with and without terminal value calculations, are compared with (ex-ante) market prices to give an indication of the error introduced by each technique in truncating the horizon. Comparisons of these errors show that accrual earnings techniques dominate free cash flow and dividend discounting approaches. Further, the relevant accounting features of techniques that make them less than ideal for finite horizon analysis are discovered. Conditions where a given technique requires particularly long forecasting horizons are identified and the performance of the alternative techniques under those conditions is examined.

JEL Classification: G12, M41

Suggested Citation

Penman, Stephen H. and Sougiannis, Theodore, A Comparison of Dividend, Cash Flow, and Earnings Approaches to Equity Valuation. Available at SSRN: https://ssrn.com/abstract=15043 or http://dx.doi.org/10.2139/ssrn.15043

Stephen H. Penman

Columbia Business School - Department of Accounting ( email )

3022 Broadway
New York, NY 10027
United States
212-854-9151 (Phone)
212-316-9219 (Fax)

Theodore Sougiannis (Contact Author)

University of Illinois at Urbana-Champaign - Department of Accountancy ( email )

360 Wohlers Hall
1206 South Sixth Street
Champaign, IL 61820
United States
217-244-0555 (Phone)
217-244-0902 (Fax)

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