A Fundamental Investor’s Guide on Reverse Engineering in Equity Valuation

Abstract

This paper reviews literature on reverse engineering in equity valuation from the perspective of a fundamental investor. Despite a history of over 80 years, the literature on reverse engineering shows no clear consensus on the modelling, conceptualisation and operationalisation of the technique. Moreover, the literature often includes ad-hoc, speculative assumptions that put many empirical results in question if treated transparently. We derive a new assessment framework for applied reverse engineering in accounting-based equity valuation from the perspective of a fundamental investor. Based on the framework, we find that there is no approach to reverse engineering that sufficiently fulfils the needs of fundamental investors in the literature. In search of a remedy, we derive a model based on the Ohlson (1995) model that is tailored to reverse engineering and complements a more extensive fundamental analysis. We further provide implications of our insights for investors and identify potential directions of future research based on these insights, e.g. stock screening.

Keywords: Reverse Engineering, Residual Income Valuation, Financial Statement Analysis, Fundamental Investor, Value Investing

JEL Classification: M41, G11, G12, G14, G17, G32