The Equivalance of Dividend, Cash Flows and Residual Earnings Approaches to Equity Valuation Employing Ideal Terminal Value Expressions

52 Pages Posted: 17 Jul 2000

See all articles by Lucie Courteau

Lucie Courteau

Free University of Bozen-Bolzano - Faculty of Economics and Management

Jennifer L. Kao

Independent

Gordon D. Richardson

University of Toronto - Rotman School of Management

Date Written: February 3, 2000

Abstract

Recently, Penman and Sougiannis (1998) and Francis, Olsson and Oswald (1999) compared the bias and accuracy of the dividend discount model (DDM), discounted cash flow model (DCF), and Edwards-Bell-Ohlson residual income model (RIM) in explaining the relation between value estimates and observed stock prices. Both studies report that, with non price-based terminal values, RIM outperforms DCF and DDM.

Our primary research objective is to explore whether, over a five-year valuation horizon, DDM, DCF and RIM are empirically equivalent when Penman's (1998) theoretically "ideal" terminal value expressions are employed in each model. Using Value Line terminal stock price forecasts at the horizon to proxy for such values, we find empirical support for the prediction of equivalence between these three price-based valuation models.

Our secondary research objective is to demonstrate that, within each class of the DCF and RIM valuation models, the model that employs Value Line forecasted price in the terminal value expression will generate the lowest pricing errors, compared to models that employ non price-based terminal value under an arbitrary growth assumption. Results indicate that, for both DCF and RIM, price-based valuation models outperform the corresponding non price-based models by a wide margin.

We also revisit the issue of the apparent superiority of RIM, and find that this result does not hold in a level playing field where an approximation of ideal terminal values is employed. In fact, the price-based RIM model is marginally outperformed by the price-based DCF and DDM models, in terms of pricing errors as well as its ability to explain current market price.

JEL Classification: G12, M41

Suggested Citation

Courteau, Lucie and Kao, Jennifer L. and Richardson, Gordon D., The Equivalance of Dividend, Cash Flows and Residual Earnings Approaches to Equity Valuation Employing Ideal Terminal Value Expressions (February 3, 2000). Available at SSRN: https://ssrn.com/abstract=233399 or http://dx.doi.org/10.2139/ssrn.233399

Lucie Courteau

Free University of Bozen-Bolzano - Faculty of Economics and Management ( email )

Faculty of Economics and Management
Piazza Università 1
39100 Bozen-Bolzano (BZ), Bozen 39100
Italy

Gordon D. Richardson

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada
416-946-8601 (Phone)
416-971-3048 (Fax)

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