Applying Merton’s Valuation Adjustment for Incomplete Information...and Do You Need To?

23 Pages Posted: 28 Sep 2018 Last revised: 16 Oct 2019

See all articles by Thomas J. O'Brien

Thomas J. O'Brien

University of Connecticut - Department of Finance

Date Written: September 16, 2019

Abstract

Bodnaruk and Ostberg (2009) introduced a simple formula for applying Merton’s (1987) incomplete-information adjustment to a stock’s required rate of return. The adjustment, which is based on market capitalization, idiosyncratic risk, and extent of investor ownership, should in principle improve discount rate estimates used in valuation. This article helps bridge the gap between theory and practice by explaining the application of the adjustment formula and providing adjustment estimates for some example U.S. stocks. The adjustment estimates tend to be material for volatile stocks with a relatively low percentage of shares held by institutional funds.

Keywords: Valuation, Discount Rate, Incomplete Information, Idiosyncratic Risk, Shareholder Base

JEL Classification: G15

Suggested Citation

O'Brien, Thomas J., Applying Merton’s Valuation Adjustment for Incomplete Information...and Do You Need To? (September 16, 2019). Managerial Finance, Forthcoming; University of Connecticut School of Business Research Paper No. 18-31. Available at SSRN: https://ssrn.com/abstract=3247256 or http://dx.doi.org/10.2139/ssrn.3247256

Thomas J. O'Brien (Contact Author)

University of Connecticut - Department of Finance ( email )

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