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`Notes on Comparison of Valuation methods

In theory, given predictions of payoffs to infinity, all valuation methods are supposed
to provide a similar prediction of value. However, due to impracticalities with
forecasting an infinite stream of fundamentals, analysts use simplifying assumptions
especially in the LR and make detailed forecasts only for a limited horizon.
To get some inferences on the quality of each valuation methodologies, we need to
compare them based on their achievement of objectives. Valuation objectives are:
i)
ii)

To explain observed stock prices, assuming efficient capital markets


To predictably generate positive or negative abnormal returns, assuming
inefficient capital markets

Thus, the quality of each valuation methods can be judged based on which methods
best explains share prices and which has the most predictive power with respect to
future returns.
1a. A comparison of dividend, cash flow and earnings approach to equity
valuation (Penman and Sougiannis, 1998)
Research topic:
Dividend, FCF and AE are equivalent when respective payoffs are forecasted to
infinity. However, in practice forecasts are made over finite horizons.
Penman and Sougiannis (1998), through their research, aimed to:
i)
ii)

Compare the value estimated by DIV, FCF and AE in finite horizon using
actual realizations as proxies for expected values to assess accuracy of
forecast methods.
Identify which method work best for different finite horizons eg. Over 1
year, 2, 5 or 8?

Assumptions:
Ex-post realisations are equal to ex-ante rational expectations and that markets are
efficient. Valuations are calculated with or without CV to account for value of firm
after T.

Methodology:
Accuracy of valuation methods is assessed by comparing actual prices against ex-post
payoffs prescribed by the model (inputs are ex-post accounting realizations).
Valuation errors per unit of price at t are calculated as:

Errort = [Pt Valuet ]/Pt 


where Valuet = portfolio intrinsic value at t calculated from actual ex post payoffs,
that is realizations of ex ante payoffs; Pt = observed portfolio price at t. 
Results:
Benchmark error = cost of capital * Actual Price = Error expected to observe
1. Errors for DIV are large and positive for short horizon but decline towards
benchmark as more dividends are included in calculation.
2. Errors for FCF are large and positive for ALL horizons (Greater than 150% of
actual price) and that errors are lower if AE is used.
3. Average four-year forecast horizon and a terminal value with growth. The
related average prediction errors are: 6.1 per cent for the AEM; 76.5 per cent
for the DCF; 16.7 per cent for the Gordon growth method.
This shows that errors are lower using the AE-based method rather than
the DCF method, with Gordon dividend estimates falling in between.
1b. Comparing Accuracy and Explainability of DIV, FCF and AE Valuation
(Francis, Olsson and Oswald, 1997)
Research Question:
Another study providing empirical evidence on the reliability of the value estimates
obtained from three valuation methods (based on dividends, free cash flows and
abnormal earnings) was conducted by Francis et al. (1997).
By using forecasts supplied by Value Line over a five-year forecast horizon for the
period 198993, they compared valuation methods in terms of:
. Accuracy: difference between the value estimate and the current market price,
divided by the market price. (Note that accuracy is measured inversely in
Penman and Sougiannis, 1998.) This enables us to identify the most reliable
method. 
. Explainability: ability of the value estimates to explain cross-sectional variation in
current price. This means to control for systematic over- or underestimation by
valuation methods. 

Assumptions:
Three different assumptions are used for terminal value:
-

Long-term price-to-earnings ratio provided by Value Line;


Zero growth perpetuity;
Constant growth perpetuity (4 per cent). 

Francis et al. (1997) use Value Line annual forecasts of the payoffs in these models to
calculate value estimates thus their empirical evidence is based on forecast (not
realised) proxies of the payoffs 

Methodology:
-

The test of accuracy is based on the measurement of prediction errors (both


signed and absolute mean and median),

Methodology used to test for explainability is based on regressing market


prices on values predicted by dividend, free cash flow and abnormal
earnings methods and measuring the incremental contribution made by each
method.

Results:
As regards accuracy, the empirical evidence (adapted in Table 8.10) shows:
- The most accurate value estimates also explain the most variation in
contemporaneously observed prices 
- Terminal value based on Value Line 35 year ahead P/E forecast:

Slight differences between methods: dividend and abnormal earnings-based


methods perform similarly, while the discounted cash flow method performs
slightly worse 

- When continuing/terminal value is included, all of the methods tend to


underestimate stock prices 
- With the perpetuity-based continuing/terminal value (growth 4 per cent), AE-based
estimates are more accurate than the estimates from the Gordon growth method and
the discounted cash flow the median absolute prediction error for the AE is about
two-thirds that of the DCF (30 per cent vs 45 per cent), and less than one-half that of
the GGM (30 per cent vs 70 per cent). 

With regards to explainability,


Using univariate regressions, AEM and DDM consistently explain more in the
variation of current stock prices than DCF .

For OLS regressions, the difference is especially pronounced for the


perpetuity- based continuing/terminal value specification when AEM (DDM)
estimates explain 71 per cent (51 per cent) of the variation in current prices,
compared with 23 per cent for DCF estimates 
As regards multivariate regressions, the empirical evidence shows that only the
AEM has incremental power.
In contrast, neither DCF nor DDM estimates add much to explaining variation
in prices after controlling for the other two value estimates. 
It is essential to note that the AE-based method does not provide less reliable value
estimates for firms where we expect book values to poorly reflect intrinsic values (i.e.
firms with high R&D expenditures and high levels of accounting discretion).
The results actually suggest the opposite: AE-based estimates for high R&D spending
firms are more accurate and explain more in the variation of the current stock prices
than DCF and DDM value estimates. This evidence confirms that the AEM obtains
regardless of how biased the accounting is. 
Limits to the studies:
The main limit of the above studies (Francis et al., 1997; Penman and Sougiannis,
1998) relates to an inconsistent application of the DDM (Lundholm and OKeefe,
2000).
The hypothesis is to estimate the valueas explicit dividend forecasts over a five-year
horizon plus terminal value (using a growth rate, g = 0 or 4 per cent in perpetuity).
The dividend forecasts for five years account for a small fraction of current
market value. Then, if g = 0, in practice we observe a huge permanent increase in
dividends from year 5 to year 6, with dividends equal to earnings in year6 and
beyond. Instead, Francis et al. (1997) and Penman and Sougiannis (1998)
forecast dividends in year 6 as DIVt+5(1+g). Naturally they find the DDM to
perform poorly.
Dechow (1999) capitalized annual analysts forecasts of earnings as CV in DDM
and found that DDM is about as successful as AE method!!