Methods of choice in the valuation of

ordinary shareholders’ equity:

evidence from theory and practice
WS Nel
Department of Accounting
University of Stellenbosch

Abstract
The question that inevitably surfaces in practice, and certainly in lecture halls, is
which equity valuation method is superior. Popular opinion holds that academia and
investment practitioners may have different preferences in this regard. This article
investigates which primary minority and majority equity valuation methods are
advocated by academia, and how well these preferences are aligned with the equity
valuation methods that investment practitioners apply in practice. The research results
reveal that, contrary to popular belief, academia and practice are fairly well aligned in
terms of preferred equity valuation methods, with notable differences in their
respective approaches.
Keywords
Discounted cash flow Free cash flow
Discounts Majority interest
Dividend growth model Minority interest
Earnings before interest, tax, depreciation Premiums
and amortisation
Equity valuation

1 Introduction
Internationally, there is a drive to ascertain how “best practitioners” value investments in
emerging markets such as South Africa. Bruner, Conroy, Estrada, Kritzman and Li
(2002:319) emphasised the need for academia and practitioners in emerging markets to
converge on mainstream valuation practices, a phenomenon that is common in developed
markets. Current corporate valuation policy, as applied in practice, provides a benchmark
for best practice for investment practitioners. It also gives academia insight into which
equity valuation methods are applied most frequently in practice. Although a
PricewaterhouseCoopers (PwC) valuation methodology field survey, conducted among
investment practitioners in 2008, made valuable contributions in this regard, no such
research has yet been conducted among academia. The contribution of this study is that it
facilitates the convergence of, firstly, academic thinking about valuation methods, and,

Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135 117

Methods of choice in the valuation of ordinary shareholders’ equity: evidence from theory and practice

secondly, mainstream valuation practices between academia and investment practitioners.

To this end, the research results will present academic consensus on valuations and
highlight differences in respect of valuation practices between academia and investment
practitioners.
According to Bruner et al. (2002:319), valuations are affected by factors such as
liquidity, corruption, volatility and taxes, which differ between developing markets and
developed markets. Investment inflows into emerging markets are significant, and
improved valuation practices could significantly affect the welfare of investors. In addition,
many emerging markets that are closely watched by international investors grow at real
rates of two to three times those of developed countries. Developing countries also account
for large parts of the world population, land mass and natural resources.
Numerous researchers have endeavoured to determine which equity valuation methods
are superior (Berkman, Bradhury & Ferguson 2000; Biddle, Bowen & Wallace 1999;
Courteau, Kao, O’Keefe & Richardson 2001; English 2001; Goedhart, Koller & Wessels
2005; Hartman 2000). However, there is no evidence of research that compares academia’s
preferences regarding equity valuation methods with those of investment practitioners.
This study investigates academic consensus among chartered accountants regarding the
use of equity valuation methods and whether the general concern about the gap between
theory and practice (Triantis 2005:8; Ralston 2003:1; Bernstein 2008) is warranted.
Although this exploratory study focuses on a specific target audience in the wider academic
community, the research results indicated that the topic warrants further investigation,
which the author intends pursuing in future research. However, for the purpose of this
article, the reference to academia will specifically refer to chartered accountants in
academia. The emphasis is on academia’s perception of the most suitable equity valuation
methods, and how this compares with the preferences of investment practitioners in South
Africa.
The next section deals with the objectives of the research, followed by a discussion of the
value of the research. A theoretical framework and a literature review on equity valuations
follow in sections 4 and 5. Sections 6 and 7 describe the research methodology and the
survey results regarding the equity valuation methods preferred by academia, followed by a
gap analysis between theory and practice in section 8. The last section of the article
contains final comments on the topic.

2 Objective of the research

The objective of the research is to answer two questions:
(1) Which primary equity valuation methods are preferred by academia?
(2) Is the general concern about a gap between what is lectured in academia and what is
applied in practice warranted?
This article will focus on the primary equity valuation methods preferred by academia and
those applied by investment practitioners. The research forms part of a wider research
project aimed at establishing the nature and size, if any, of the gap between theory and
practice regarding equity valuations, that is, primary methods of equity valuation,
secondary methods of equity valuation, discount rates, and so on.

118 Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135

 Nel

3 Value of the research

Lecturers in academia may find it difficult to ascertain which equity valuation methods are
superior. As such, the results of the academic survey present a valuable synopsis of
academic consensus as a guideline on equity valuation. The results also facilitate the
convergence of academic thinking in this regard.
There appears to be a general concern that investment practitioners and academia operate
in isolation, both parties being slightly suspicious of the value that academic rigour, on the
one hand, and the pressures in the marketplace, on the other, might add to their respective
approaches (Ralston 2003:1). This study investigates whether the general concern about the
existence of a gap between theory and practice, as indicated by Ralston and others (Triantis
2005:8; Bernstein 2008), is warranted and, if so, how academia and investment
practitioners can converge on valuation practices. Ultimately, the research results seek to
enhance the quality of valuation teaching in academia and the practice of valuation methods
in the marketplace.

4 Theoretical framework for equity valuation methods

Equity valuation is not a precise science (Pratt 2006:10). A comparison between the values
derived by the use of different valuation methods and the actual share price will attest to
this. Although various methods can be applied to equity valuation, this study focuses on the
following five approaches to valuations:
□ Discounted cash flow (DCF) valuations1, which for the purpose of this article, will
consist of three subcategories:
- dividend-based methods, that is, the dividend growth model (DGM) and the
dividend yield model (DYM)
- the free cash flow (FCF) method
- earnings-based methods, that is, earnings before interest, tax, depreciation and
amortisation (EBITDA) cash flow model and the earnings yield model (EYM)
□ Relative valuations, otherwise known as multiples
□ The residual income approach, specifically the economic value added (EVA) model
□ Asset-based valuations
□ Rule-of-thumb (ROT) valuations

4.1 DCF valuations

According to modern finance theory, DCF valuations determine the present value of an
asset by discounting future cash flows that the asset is expected to generate at a discount
rate reflecting the level of risk associated with these cash flows (Damodaran 2007:4). In
mathematical terms, this can be formulated as

1
The valuation methods included under the DCF approach may be classified in a number of ways. The
EYM could, for example, also be classified as an earnings-based, yield-based or capitalisation of
earnings approach. For the purpose of this article, however, earnings is regarded as a proxy for cash
flow and are therefore classified as a DCF approach.

Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135 119

Methods of choice in the valuation of ordinary shareholders’ equity: evidence from theory and practice

t=n ε (CFt)
V0 = ∑
t
t=1 (1 + re)

Two different cash flow measures, dividends (D) and FCF, and two different proxies for
cash flows, EBITDA and earnings, are considered in this article.

4.1.1 Dividend-based methods

Assuming a constant growth in cash flows, the DGM values a share in the current time
ε
period (V0) as the expected dividend in year t ( (Dt)), divided by the difference between
the cost of equity (re) and the expected growth rate in perpetuity (g):

t=∞ ε (Dt)
V0 = ∑
t=1 (re - g) t

Although the DGM is a simple approach, it is based on a number of unrealistic assumptions

such as the premise that an entity will exist ad infinitum and the assumption of constant
growth. Despite these limitations, Damodaran (2007:13-17) identified three scenarios in
which the DGM can be useful. Firstly, it can be used as a floor value for firms where the
cash flow to equity exceeds the dividends. Secondly, it can produce a realistic value for
firms that pay out their FCF to equity as dividends. Thirdly, the DGM can be used in cases
where the estimation of cash flows is difficult or impossible.
The DYM values a share in the current time period (V0) as the expected dividend in year
t( ε (Dt)) divided by the required rate of return (RoR):
ε (Dt)
V0 =
RoR

Although the DYM is a straightforward application, it fails to take the growth in the value
of a share into account and is therefore not as conceptually sound as the DGM. It also
suffers from the same criticism as the DGM, in that the nature of the calculation is based on
the perpetuity principle, which is unrealistic.

4.1.2 The FCF model

The FCF model assumes that a firm’s equity value equals the present value of future free
cash flows – in other words, that all FCF is available to be paid out to shareholders. There
are two main FCF models, namely the free cash flow to equity (FCFE) model and the free
cash flow to the firm (FCFF) model. FCFE refers to cash flow that is available after all
reinvestment needs and debt payments have been accounted for, that is, FCFE = net income
+ depreciation + capital expenditure + change in noncash working capital – (new debt
issued – debt repayments) (Damodaran 2007:20). In its simplest form, the constant growth
FCFE model, that is, when valuing shares in a mature company, values a share in the
current time period (V0) as the expected FCFE in year t (FCFEt), divided by the difference
between the cost of equity (re) and the expected normal growth rate in perpetuity (g):

120 Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135

 Nel

t=∞ FCFEt
V0 = ∑
t=1 (re - g) t

When valuing shares in a growth company, the FCF model splits the valuation of a share
between the growth period (also known as the planning period) and the valuation of the
period beyond the planning period, referred to as the terminal value (TV). For the planning
period, the share is valued in the current time period (V0) by projecting expected future free
cash flows to equity over n years, and discounting these cash flows at the cost of equity
(re):
t=n FCFEt
V0 = ∑
t=1 (1 + re) t

The terminal value, that is, the continuing value beyond the planning period, at the end of
the planning period (TVn), which is usually calculated as the following period’s FCFE
divided by the difference between the cost of equity and the expected growth rate, is
discounted at the cost of equity (re) and added to the value obtained for the planning period.
Once the firm reaches a stable growth rate after n years, the formula becomes

t=n FCFEt TVn

V0 = ∑ +
t=1 (1 + re) t (1 + re) n

When valuing the firm, as opposed to valuing the equity, the formula changes to the
following:

t=n FCFF*t TVn

V0 = ∑ +
t=1 (1 + WACC) t (1 + WACC) n

*FCFF = after-tax operating income + depreciation – capital expenditure – change in working capital
There are two main differences between FCFE and FCFF. Firstly, FCFE is calculated after
taking interest payments and debt cash flows into account, whereas FCFF is calculated as if
the firm has no debt, and therefore enjoys no tax benefits from interest expenses. Secondly,
the FCFE model discounts future cash flows at re, whereas FCFF is discounted at the
weighted average cost of capital (WACC).
The emphasis in the FCF model is on cash generated by the firm’s operations after taking
into account the cash required to reinvest in terms of capital expenditure and working
capital in order for the firm to achieve its growth objectives or, phrased differently, cash
flows that could be withdrawn from an entity without lowering the current growth rate
(Kamstra 2003:50). This makes the FCF model relatively flexible since the key variables
can be tailored to allow for a change in the way the company conducts its business in the
future. It also overcomes the double counting criticism against valuation methods that
discount earnings.

Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135 121

Methods of choice in the valuation of ordinary shareholders’ equity: evidence from theory and practice

4.1.3 Earnings-based methods

The EBITDA cash flow model is similar to the FCF model, but uses EBITDA as a proxy
for cash flows. A myriad of factors renders this approach inappropriate for the valuation of
equity. The use of EBITDA as a substitute for cash flow is conceptually flawed, and, in the
author’s opinion, should not be employed as a DCF approach. Despite the obvious fact that
it ignores, inter alia, interest, taxes, changes in working capital and capital expenditure, the
discounting of earnings is conceptually incorrect since it results in double counting – in
other words, it treats earnings both as cash payouts and a base for future growth.
Consequently, the use of EBITDA as a proxy for cash flows will result in the overvaluation
of shares.
The EYM is the reciprocal of the P/E ratio, and as such, could probably also be regarded
as a relative valuation model. The EYM values a share in the current time period (V0) as
ε
the expected earnings in year t ( (Et)), divided by the required rate of return (RoR):

ε (Et)
V0 =
RoR

The EYM is similar to the DYM except that it uses earnings as a proxy for cash flows.
Although the EYM is a simple application, it is based on earnings, which may be
manipulated.
The main criticism levelled against DCF models is that they are based on the discounting
of forecast future cash flows, the estimation of which may be unreliable (Kamstra 2003:49).
The FCF approach, in particular, can be fairly cumbersome and is based on a range of
sensitive assumptions (Lie & Lie 2002:1). Consequently, valuations based on the DCF
approach are augmented by other valuation methods such as multiples, which are used
extensively in practice as plausibility checks (Bhojraj & Lee 2002:407).

4.2 Relative valuations

Relative valuations, or multiples, estimate the value of an asset by using a comparable asset
price/ratio as a benchmark in relation to a common variable, such as earnings or sales.
Many investment practitioners calculate a sector average multiple and multiply it by a
specific entity’s earnings or sales, for example, to value the entity’s equity (Goedhart et al.
2005:1). The starting point is usually the identification of a benchmark multiple of a similar
listed entity in the same sector, or the calculation of the average of that multiple for the
sector in which the entity operates.
Valuations based on multiples equate the value of a share in the current time period (V0)
to the product of a specific multiple, such as the P/E ratio, and a specific value driver, such
as earnings per share (EPS), so that
V0 = P/E ratio x EPS

Although multiples are used extensively in practice, most are criticised on the grounds that
their value drivers are based on historical accounting data such as earnings, which may be
manipulated. Wetherilt and Weeken (2002:400) even suggest that the DYM is preferred
above the P/E ratio, for example, as a result of accounting malpractices at companies,
which have raised doubts about the quality of earnings.

122 Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135

 Nel

4.3 The residual income approach

The EVA model is one of the most widely used variants of the residual income approach
(Damodaran 2007:37). EVA, a registered trademark of Stern Stewart and Company, which
was popularised during the late 1980s, is based on the premise that in order for a company
to create wealth for its owners, its earnings on its invested capital must exceed the cost of
this capital (Biddle et al. 1999:2). EVA is calculated as the product of the excess return
made on an investment, that is, the excess return over the weighted average cost of capital
(ROI – WACC), and the capital invested (CI) in that investment. In its simplest form, the
EVA model discounts EVA at the WACC:

t=n EVAt
V0 = ∑
t=1 (1 + WACC) t

Several researchers have demonstrated the equivalence of the DCF models and EVA
models, that is, that they yield similar valuation results (Hartman 2000:163; Lundholm &
O’Keefe 2001:332; Courteau et al. 2001:655). However, the EVA model may prove
somewhat cumbersome, since numerous adjustments to profit figures may be required in
order to reach an appropriate EVA. Stern Stewart, for example, has developed more than
160 potential adjustments to derive an appropriate EVA (Biddle et al. 1999:6). Opponents
of the EVA model may argue that it is based on historical accounting figures that may be
distorted.

4.4 Asset-based valuations

Asset-based valuations are based on net asset value (NAV), that is, the market value of
assets less the market value of liabilities. The NAV approach is typically used as a floor
value – in other words, the lowest price a share is worth. The NAV approach should
therefore not be used as a primary method to value the equity of a going concern, but rather
as a plausibility check or a floor value for a more comprehensive approach.

4.5 ROT valuations

ROT are formulae which result in ranges of values for certain types of businesses and are
generally used when small businesses are sold. An advertising agency, for example, may
use a ROT, such as 75% of annual billings, and may require an income guarantee, while a
coffee shop may consider, say, 40 to 45% of annual gross sales, plus the value of their
inventory (Hendrikse & Hendrikse 2004:130). Although ROT provide an inexpensive and
easy method to value a business, they are rarely used to value equity (Sliwoski 1999:1).
Apart from the fact that, technically speaking, ROT are not acceptable valuation methods
because they are based on the premise that history is bound to repeat itself, they vary
according to different geographical locations and do not remain constant.

5 Literature review
The literature review revealed that, although a few earlier studies were devoted to a gap that
presumably exists between theory and practice with regard to investment management,
there is no research available on how well the equity valuation methods advocated by
academia are aligned with the equity valuation methods applied in practice.

Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135 123

Methods of choice in the valuation of ordinary shareholders’ equity: evidence from theory and practice

5.1 Gap analysis

The first formally reported study in this area was conducted by the American Finance
Association (Upton 1949) in 1948. Twenty-seven lecturers, representing 20 schools, met to
discuss the methods of teaching Business Finance, during the American Finance
Association convention in Cleveland in the USA. The convention delegates argued that
business school education failed to meet the needs of businesses in practice.
In a similar study, Wendt (1966:422) conducted a survey at 205 business schools and
found that investment faculties lagged behind investment practitioners by more than a
decade and concluded that there was a need for academia to catch up. Smith and
Goudzwaard (1970:344) found that the gap between what is taught by academia and what is
applied in practice does not only exist, but is also widening. Although ample research has
since been conducted on the topic of equity valuation methods, to the best of the author’s
knowledge, no survey of academic preferences or gap analysis has yet been conducted on
how the theoretical models advocated by academia are aligned with the methods actually
applied in practice. There is a specific need for clarification in relation to whether certain
methods are preferred/regarded as superior to others, and which methods are more suited to
a supporting capacity.
One should bear in mind that the respective valuation methods are not used in isolation,
but in conjunction with other valuation methods. Most investment practitioners prefer
certain equity valuation methods as their primary methods, which they will back up with
other secondary equity valuation methods as a plausibility check (Liu, Nissim & Thomas
2002:1; Bhojraj & Lee 2002:407).

5.2 Evidence from previous research

Several authors have shown that the DCF approach is the most accurate and flexible equity
valuation method (Goedhart et al. 2005:1; Courteau, Kao, O’Keefe & Richardson 2003:24;
Berkman et al. 2000:81). Despite the volume of research in support of the superiority of the
DCF method, a carte blanche approach in the application of the DCF method is ill advised.
Different circumstances warrant different equity valuations, depending on the nature of
the company being valued. EBITDA, for example, may be an appropriate value driver
when valuing a company with a five-year earnings history, but less so when valuing the
equity of a capital intensive entity (Harrington 2004:44). The latter may warrant a DCF
calculation. However, Kim and Ritter (1999:410) emphasise the fact that when valuing
young US companies, future cash flow projections are usually imprecise and may need to
be augmented with comparable firm multiples.
The bulk of the research on multiples focuses on key value drivers, especially earnings
and cash flows, with a general preference for earnings, as confirmed by Liu, Nissim and
Thomas (2001:153), Abukari, Jog and McConomy (2000:22), Liu et al. (2002:23), Cheng
and McNamara (2000:367) and Volker and Richter (2003:216). Although most researchers,
including Fernándes (2001:2) and Courteau et al. (2003:24), concur that multiples are not
the most accurate equity valuation techniques, approximately 90% of valuations are relative
valuations and 50% of acquisition valuations use a combination of multiples and
comparable companies (Damodaran 2002:59).
The EVA model is used as a valuation method and a performance measurement tool.
Research results have indicated that the FCF model, the DGM and the EVA model give
similar value estimates, provided that all the forecast items and assumptions are identical

124 Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135

 Nel

(Plenborg 2001:316; Levin & Olsson 2000:17). However, studies by Penman and
Sougiannis (1998:376) and Francis, Olsson and Oswald (2000:69) suggest that, when these
assumptions are relaxed, the residual income approach yields superior results, that is, the
model performs more accurate valuations than the FCF and DGM models.
The NAV and ROT methods are not suitable primary equity valuation methods. The
NAV approach is generally used as a plausibility check to more sophisticated methods,
while the ROT methods are a quick and tainted means of establishing ranges of values for
predominantly small businesses. Although the ROT methods are inexpensive and easy to
use to value a business, they are not sound equity valuation methods and are rarely used
(Sliwoski 1999:1).

5.3 Evidence from practice

PwC conducted a comprehensive valuation methodology survey among 25 investment
practitioners in 2008. The participating investment practitioners included the investment
arms of the four major banks and the corporate finance divisions of the “big four” auditing
firms. The PwC survey covered a wide spectrum of issues pertaining to valuations, ranging
from the most frequently used valuation approaches, to the methods preferred in the
calculation of discount rates. The questions relating to the most frequently used valuation
approaches were scaled on a frequency table between 0 and 3, where 0 indicates that the
method is seldom or never used, 1 that the method is often used, 2 that the method is fre-
quently used and 3 that the method is always used. The most popular valuation approaches
currently used in practice, according to the PwC survey, are contained in Figure 1.
Figure 1 Equity valuation approaches most frequently used in practice in South
Africa

Discounted Cash Flow Approach

3.00
2.50
2.00
1.50
Economic Value Added 1.00 Multiples
0.50
-

Other Net Assets Approach

Source: PricewaterhouseCoopers (2008:13)

According to the PwC survey, the DCF approach (2.75) is the most popular approach to the
valuation of equity currently used in practice. The second best alternative is multiples (1.5),
followed by the net assets approach (0.75). Although the PwC survey did not specify the
methods that resided under the “Other approaches” category, this category scored an
insignificant 0.25. None of the respondents indicated that they considered/used the EVA
model.

Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135 125

Methods of choice in the valuation of ordinary shareholders’ equity: evidence from theory and practice

The PwC survey identified the valuation approaches categorically and did not refer to
specific methods for minority and majority equity valuations. Hence, a comparison between
specific equity valuation methods as suggested by the respondents to the academic survey
and the specific equity valuation methods currently applied in practice, is somewhat
obscure.
Although the PwC survey neglected to distinguish between minority and majority equity
valuation methods, it did include a section on the application of discounts and premiums.
According to the PwC survey results, 60% of the respondents indicated that they apply a
minority discount to the DCF approach, while 12% and 16% apply a minority discount to
multiples and the net asset approach, respectively. Similarly, 28% of the respondents
indicated that they apply a control premium to the DCF approach, while 84% and 16%
apply a control premium to the market and the net asset approaches, respectively. Although
there are exceptions such as minority freeze-out equity valuations (Bates, Lemmon & Linck
2006:682), research supports the application of a control premium and/or a minority
discount. Graham and Lefanowicz (1999:172) found that since majorities have the ability to
control the firm’s investing, financing and operating activities, their market values include a
premium. Minority shareholder market values, however, include a discount.

6 Research methodology
In order to achieve the objective of the research, a two-pronged approach was adopted:
(1) Establish academic consensus on primary equity valuation methods.
(2) Establish how the primary equity valuation methods that were identified in (1)
compare with the methods investment practitioners apply in practice.
In order to ascertain academic consensus on primary equity valuation methods, in 2008 a
survey was conducted at 12 universities in South Africa. The PwC survey will be used as a
reflection of the preferences of investment practitioners in the marketplace.

6.1 Survey design and distribution

A draft survey was prepared and a link to an electronic database emailed to five lecturers.
Their feedback and recommendations were incorporated in the questionnaire and the
database cleared of these pilot responses. The final survey contained 25 questions and took
approximately 15 minutes to complete.
The South African Institute of Chartered Accountants (SAICA) emailed a link to the
final, electronic, web-based questionnaire to chartered accountants who work in academia.
An email reminder was sent out and the responses subsequently followed up telephonically.

6.2 Response rate

The questionnaire was sent to 446 chartered accountants in academia. Of the emails sent
out, 36 were returned to the sender as a result of invalid addresses. Although a potential
target audience of 81 lecturers opened the email, which may seem small at first glance, one
should bear in mind that not all lecturers in academia lecture finance. Only 54 lecturers
currently lecture, or have in the past lectured, finance, as confirmed by the relevant
divisions at the respective universities. The effective target audience at the universities
therefore consisted of 54 lecturers only.

126 Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135

 Nel

A total of 35 lecturers of the potential 54 respondents completed the questionnaire. All

the completed questionnaires were usable, constituting an effective response rate of 65%.
Although in terms of absolute numbers, 35 responses may seem small, one should bear in
mind that similar research conducted by PwC in 2008 yielded only 25 responses (PwC
2008:1). The 35 responses originated from 10 universities, which render them
representative of the general thinking in academia on the topic of equity valuations. The
fact that SAICA supported the research initiative decreases the likelihood that a higher
number of responses would have been achieved in any other cost-effective way. The profile
of the lecturers who participated in terms of qualifications and finance-specific lecturing
(discussed in section 6.3) renders the results useful.

6.3 Profile of participants

The participants in the academic survey were suitably qualified lecturers with ample
lecturing experience on the topic of valuations. All the participants were members of
SAICA. In addition, 80% of the participants had master’s degrees, of whom 20% also had
PhDs.
These participants represented 10 of the universities in South Africa, indicating that the
results are a fair reflection of general academic thinking on valuations. One can therefore
conclude that the participants in the academic survey constituted a strong academic
knowledge base to respond to the questions dealing with equity valuations.

6.4 Survey questions

The academic survey was divided into three sections. The first section dealt with specific
equity valuation methods such as the FCF model and multiples. Section 2 focused on the
discount rate, posing questions about the most appropriate method for calculating the
discount rate and specific questions on the capital asset pricing model. The third section
covered the profile of the participants. This article will focus on the first and third sections
of the questionnaire, while the remaining section will form part of further research. One
should bear in mind that the results are merely a reflection of the beliefs and opinions of
chartered accountants in academia.
The emphasis in this article is on two questions in the academic survey that were
designed to establish which equity valuation methods, according to academic thinking,
should be used most frequently in practice when valuing a minority and/or a majority
interest in an entity’s equity.
The questions focused on the following:
(1) the primary equity valuation methods that should be used most frequently when
valuing a minority interest in an entity’s equity
(2) the primary equity valuation methods that should be used most frequently when
valuing a majority interest in an entity’s equity.
Respondents were asked to indicate how frequently the respective valuation methods
should be used on a scale of 0 to 4, where 0 indicates that the method is never used, 1 that
the method is almost never used, 2 that the method is sometimes used, 3 that the method is
almost always used, and 4 that the method is always used. The academic survey results
discussed in this article reflect those alternatives that respondents indicated should always

Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135 127

Methods of choice in the valuation of ordinary shareholders’ equity: evidence from theory and practice

or almost always be used in practice, that is, the percentage of respondents who answered 3
or 4.

7 Evidence from theory

Although various theoretical methods can be used to value an entity’s equity, lecturers in
academia and investment practitioners may have distinct preferences. This section deals
with the equity valuation methods advocated by academia.

7.1 Primary methods of valuing a minority interest in an entity’s

equity
The results to the first question in the academic survey are presented in Figure 2 below.
Figure 2 Equity valuation methods which, according to academia, should be used
most frequently as primary equity valuation methods to value a minority
interest

Gordon dividend growth model

Dividend yield model

Free cash flow model

Multiples

Earnings yield model

Net asset value

Economic value added model

Rules of thumb

EBITDA cash flow model

Other

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

It is evident from Figure 2 that academia have a preference for dividend-based methods.
The majority (51%) of the academic survey respondents indicated that the DGM should be
used most frequently in practice. A close second choice was the DYM, at 49%.
The FCF model was the third best alternative, garnering 40% support from the
respondents. This model is based on free cash flows, which minorities are not generally
entitled to (Damodaran 2007:13). Majority stakeholders control the assets and operations of
a company, whereas minorities are only entitled to dividends and capital growth on their
shareholdings.
According to 38% of academia, multiples should be used frequently in the valuation of a
minority equity stake. A surprising result was that 31% of the respondents in academia
agree that the EYM, which is based on future earnings to derive a value for equity, should
be used as a primary minority equity valuation method. Apart from the fact that the EYM is
based on company earnings, which minorities are not entitled to, the discounting of
earnings is conceptually incorrect. Methods that garnered little support from respondents

128 Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135

 Nel

were the NAV (25%), the EVA model (18%), ROT (15%) and the EBITDA cash flow
model (15%).

7.2 Primary methods of valuing a majority interest in an entity’s

equity
The results for the second question in the academic survey are presented in Figure 3.
Figure 3 Equity valuation methods which, according to academia, should be used
most frequently as primary equity valuation methods to value a majority
interest

Free cash flow model

Earnings yield model

EBITDA cash flow model

Multiples

Economic value added model

Net asset value

Rules of thumb

Gordon dividend growth model

Dividend yield model

Other

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

As illustrated in Figure 3, the majority of academia is in agreement that the four majority
equity valuation methods that should be used most frequently in practice are the FCF
model, the EYM, the EBITDA cash flow model and multiples. Since 90% of the
respondents indicated that the FCF model should be used most frequently in practice, it is
the undisputed method of choice.
Distant second, third and fourth best alternatives are the EYM, the EBITDA cash flow
model and multiples, according to 61%, 58% and 55% of respondents, respectively. The
EYM and EBITDA cash flow models are surprising choices. The EYM is based on future
earnings to derive a value for equity, which leads to double counting, and is therefore
conceptually incorrect. In a similar vein, the EBITDA cash flow model uses EBITDA as a
proxy for cash flow, resulting in various shortcomings (highlighted in section 4.1.3) and
ultimately leading to the overvaluation of equity.
Academia demonstrated fairly strong support for the EVA model, as 48% of the
academic survey respondents indicated that the EVA model should be used frequently in
practice. Only 34% of the respondents indicated that the NAV method should be used as a
primary method for valuing a majority stake in a company. Methods that garnered little or
no support from academia were ROT (10%), the DGM (3%) and the DYM (0%). The ROT
method is not a conceptually sound basis for equity valuations, while the DGM and the
DYM are essentially minority equity valuation methods.

Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135 129

Methods of choice in the valuation of ordinary shareholders’ equity: evidence from theory and practice

8 Gap analysis
8.1 Similarities
Academia and investment practitioners agree that DCF valuation methods are superior.
Academia’s top three methods of choice for both minority and majority equity valuations
are DCF models, which corresponds with the view of investment practitioners, who
indicated that the DCF method is the superior approach to equity valuation (frequency score
of 2.75).
Aside from the DCF method, multiples, which academia appear to prefer as a majority
equity valuation method (see Table 1), were the only equity valuation method surveyed,
which the majority (55%) of academia agreed should be used frequently in practice. This
sentiment is shared by investment practitioners, who indicated that multiples are their
second most popular method of choice (frequency score of 1.5).
Academia and investment practitioners also concur on the popularity of the NAV
approach, since 25 to 34% of academia are of the opinion that the net asset approach should
be used frequently, compared to a frequency score of 0.75, according to the PwC survey.

8.2 Differences
Two major discrepancies between academia and practice relate to the use of the EVA
model and academia’s preference for certain methods as either minority or majority
valuation methods.
Only 18% of the respondents from academia indicated that the EVA model should be
used frequently in practice as a minority equity valuation method, while 48% indicated that
the EVA model should be used frequently in practice as a majority equity valuation
method. This is in sharp contrast to the evidence from practice, because none of the
investment practitioners indicated that they used/considered the EVA model to value
equity. The EVA approach scored a zero out of a potential 3 in the PwC survey, despite
evidence from research indicating the equivalence of the EVA model to the DCF approach.
The other major difference in the approach to equity valuations is that investment
practitioners do not appear to identify specific methods for majority and minority equity
valuations, but rather opt to apply minority discounts or control premiums. Approximately
84% of the respondents to the PwC survey indicated that they applied control premiums to
multiples, while 60% reported that they applied minority discounts to the DCF approach,
for example (PwC 2008:46).
Lecturers, however, appear to advocate specific methods in their lecture halls, depending
on the equity interest at stake. Table 1 indicates the preference that academia have for
certain methods as majority valuation methods vis-à-vis minority valuation methods, and
vice versa. The preference factor in the last column quantifies the magnitude of academic
preference for the specific valuation method as a majority, vis-à-vis a minority valuation
method, or vice versa.

130 Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135

 Nel

Table 1 Academic preference for valuation methods as majority or minority

valuation methods
Valuation method Minority Majority Preference Preference factor
Dividend yield model 49% 0% Minority concur
Gordon dividend growth model 51% 3% Minority 1546%
EBITDA cash flow model 15% 58% Majority 295%
Economic value added model 18% 48% Majority 174%
Free cash flow model 40% 90% Majority 126%
Earnings yield model 31% 61% Majority 95%
Rules of thumb 15% 10% Minority 47%
Multiples 38% 55% Majority 43%
Net asset value 25% 34% Majority 38%
Other 0% 0% NA NA

It is evident from Table 1 that academia prefer the DYM, the DGM and ROT as minority
valuation methods, and the remaining methods as majority valuation methods. Academia
appear to have a strong preference (preference factor of 95% or more) for the DYM, the
DGM, the EBITDA cash flow model, the EVA model, the FCF model and the EYM as
either minority or majority valuation methods, whereas the preference factor for ROT,
multiples and NAV is less significant.

9 Summary and conclusion

The research questions posed at the outset of this article were which equity valuation
methods are preferred in academia, and whether the general belief regarding the gap
between these preferences and the equity valuation methods that are applied in practice, is
warranted. To this end, current academic thinking on primary equity valuation methods was
compared with the current practice of corporate valuation policy.
The research results should be considered with caution. The research was based on the
beliefs and opinions of chartered accountants, which constitutes a specific target audience
in the broader academic environment. Some members of the academic community who
lecture valuations, are not chartered accountants. One could therefore argue that the
application of this study was narrowly defined in terms of focusing specifically on
chartered accountants, which may have obscured the generalisation of the results. However,
this should not detract from the importance of valuations as a key focus area in the SAICA
syllabus in particular, and in most other finance syllabi. As such, the research results
contribute to the continued development of the academic environment responsible for the
future training of chartered accountants. Although not considered in this study, the broader
academic environment may have similar concerns about valuations, which the author
intends investigating in further research.
The results are both reassuring and surprising. It is reassuring to know that the DCF
approach, multiples and the NAV method are equally popular among academia and
investment practitioners. Academia, and research in particular, should guide practice and
aid investment practitioners when valuing the equity of companies (Nissim & Penman
2001:109).

Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135 131

Methods of choice in the valuation of ordinary shareholders’ equity: evidence from theory and practice

The top three minority and majority equity valuation methods favoured by academia are
DCF methods. The DCF approach should always be considered as the method of choice
when valuing the equity of a going concern. This is well supported by research, which has
established the superiority of the DCF approach (Goedhart et al. 2005:1; Courteau et al.
2003:24; Berkman et al. 2000:81).
Although particular DCF methods were not specified in the PwC survey, academia
indicated a strong preference for the FCF model as a majority valuation method, while the
DGM was the only minority valuation method that garnered support from the majority of
academia. In terms of specific applications in the DCF approach, academia prefer the DGM
as the method of choice for valuing a minority interest. However, in the author’s opinion,
the DGM is not the most suitable valuation method for valuing a minority interest. If the
information is available, the method of choice should be the FCF method. The author does
concede, however, that the DGM is a far superior method to the DYM, which, in the
author’s opinion, is a poor valuation method and should be avoided.
In a perfect world, one may be tempted to argue that valuation methods other than the
DCF approach should be regarded as secondary valuation methods. However, there are
occasions when the availability of information may be limited, which may render a DCF
approach inapplicable. In such instances, valuation methods such as multiples may be used
as primary valuation methods.
The level of academic support in favour of valuation methods such as the EYM and the
EBITDA cash flow model was somewhat surprising. The EYM and the EBITDA cash flow
models discount earnings to derive an equity value, a practice which is conceptually flawed.
Also surprising was investment practitioners’ total disregard for the use of the EVA model.
Despite the fact that academia indicated a significant preference for the use of the EVA
model, and the confirmation of its accuracy as a valuation instrument by research,
investment practitioners indicated that they never use the EVA model.
The use of control premiums and minority discounts, although not explicitly tested in the
academic survey, is applied extensively in practice. Approximately 84% of the respondents
to the PwC survey indicated that they applied control premiums to multiples, while 60%
reported that they applied minority discounts to the DCF approach, for example. The
practice of arriving at a value for a minority interest by applying a discount to an equity
value calculated by means of a majority equity valuation method is not a conceptually
sound approach to equity valuations. Likewise, adding a premium to an equity value
calculated by means of a minority equity valuation method is equally flawed. Proponents of
the application of discounts and premiums do not appear to take cognisance of the fact that
there are conceptual differences between majority and minority equity valuation methods,
and the application of a discount to a majority valuation in an attempt to arrive at a value
for a minority interest will not necessarily address these differences. Although academia
may need to emphasise the fact that minority discounts and control premiums are used
extensively in practice, they would do well to indicate that this is not an accurate approach
to valuing a specific minority or majority equity stake.
The research results provide insight and a guideline to finance lecturers and investment
practitioners, in terms of academia’s perception of preferred equity valuation methods. This
study may be viewed as a first step to converge academic thinking on valuation methods.
The second step entails the convergence of mainstream valuation practices between
academia and investment practitioners. The research indicates that, although there are

132 Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135

 Nel

notable differences, theory and practice are fairly well aligned regarding primary equity
valuation methods. Whether this holds true for secondary equity valuation methods and the
calculation of discount rates is a topic for future research.

Bibliography
Abukari, K., Jog, V. & McConomy, B.J. 2000. The role and the relative importance of
financial statements in equity valuation. Working paper. Ontario: Wilfred Laurier
University:1-36.
Bates, T.W., Lemmon, T.W. & Linck, J.S. 2006. Shareholder wealth effects and bid
negotiation in freeze-out deals: are minority shareholders left out in the cold? Journal of
Financial Economics. Elsevier 81:681-708.
Berkman, H., Bradhury, M.E. & Ferguson, J. 2000. The accuracy of price earnings and
discounted cash flow methods of IPO equity valuations. Journal of International
Financial Management and Accounting 11(2):71-83.
Biddle, G.C., Bowen, R.M & Wallace, J.S. 1999. Evidence on EVA. Journal of Applied
Corporate Finance:1-19.
Bernstein, W.J. 2008. Fifty years from now. http://www.efficientfrontier.com. Accessed:
18 March 2009.
Bhojraj, S. & Lee, M.C. 2002. Who is my peer? A valuation-based approach to the
selection of comparable companies. Journal of Accounting Research 40(2):407-439.
Bruner, F., Conroy, R.M., Estrada, J., Kritzman, M. & Li, W. 2002. Introduction to
”Valuation in emerging markets”. Emerging Markets Review 3. Charlottesville:
Elsevier:300-324.
Cheng, C.S.A. & McNamara, R. 2000. The valuation accuracy of the price-earnings and
price-book benchmark valuation methods. Review of Quantitative Finance and
Accounting 15. The Netherlands: Kluwer Academic:349-370.
Courteau, L., Kao, J. & Richardson, G.D. 2001. The equivalence of dividend, cash flow and
residual earnings approaches to equity valuation employing ideal terminal value
calculations. Contemporary Accounting Research 18:625-661.
Courteau, L., Kao, J.L., O’Keefe, T. & Richardson, G.D. 2003. Gains to valuation accuracy
of direct valuation over sector multiplier approaches. Working paper. Turkey: Eastern
Mediterranean University:1-46.
Damodaran, A. 2002. Investment valuation: tools and techniques for determining the value
of any asset. 2nd edition. New York: Wiley:11-24.
Damodaran, A. 2007. Valuation approaches and metrics: a survey of the theory and
evidence. 2nd edition. Hanover, Mass: Now:3-44.
English, J.R. 2001. Applied equity analysis: stock valuation techniques for Wall Street
professionals. 1st edition. New York: McGraw-Hill:1-20.
Fernández, P. 2001. Valuation using multiples. How do investment practitioners reach their
conclusions? Working paper. Madrid: IESE Business School:1-13.

Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135 133

Methods of choice in the valuation of ordinary shareholders’ equity: evidence from theory and practice

Francis, J., Olsson J.A. & Oswald, D. 2000. Comparing the accuracy and explainability of
dividend, free cash flow and abnormal earnings equity value estimates. Journal of
Accounting Research 38(1):45-70.
Graham, R.C. & Lefanowicz, C.E. 1999. Majority and minority ownership
of publicly-traded firms: a test of the value of control using market
multiples. Journal of Business Finance and Accounting 26(1) & (2), March:1-28.
Goedhart, M., Koller, T. & Wessels, D. 2005. The right role for multiples in valuation. The
McKinsey Quarterly, March. New York: McKinsey & Company:1-3.
Harrington, C. 2004. Private equity valuation: a riddle wrapped in a mystery inside an
enigma. CFA Magazine. November. CFA Institute:44-45.
Hartman, J.C. 2000. On the equivalence of net present value and economic value added as
measures of a project’s economic worth. The Engineering Economist 45:158-165.
Hendrikse, J.W. & Hendrikse, L.H. 2004. The valuations handbook: concepts and cases.
Cape Town: Lexus Nexus Butterworths:41-66.
Kamstra, M. 2003. Pricing firms on the basis of fundamentals. Federal Reserve Bank of
Atlanta: Economic Review 1st quarter:49-70.
Kim, M. & Ritter, J. 1999. Valuing IPOs. Journal of Financial Economics 53:409-437.
Levin, J. & Olsson, P. 2000. Terminal value techniques in equity valuation: implications of
the steady state assumption. Working paper:1-26.
Lie, E. & Lie, H. 2002. Multiples used to estimate corporate value. Financial Analysts
Journal 58(2):March/April:1-11.
Liu, J., Nissim, D. & Thomas, J. 2001. Equity valuation using multiples. Journal of
Accounting Research 40(1), March:135-172.
Liu, J., Nissim, D. & Thomas, J. 2002. International equity valuation using multiples.
Working paper:1-38.
Lundholm, R. & O’Keefe, T. 2001. Reconciling value estimates from the discounted cash
flow model and the residual income model. Contemporary Accounting Research 18:
311-335.
Penman, S. & Sougiannis, T. 1998. A comparison of dividend, cash flow and earnings
approaches to equity valuation. Contemporary Accounting Research 15(3):343-383.
Plenborg, T. 2001. Firm valuation: comparing the residual income and discounted cash
flow approaches. Scandinavian Journal of Management 18:303-318.
Pratt, S.P. 2006. The market approach to valuing businesses. 2nd edition. Englewood
Cliffs, NJ: Wiley:1-23.
PricewaterhouseCoopers. 2008. Valuation methodology survey. http://www.pwc.com:1-62.
Accessed: 10 February 2009.
Ralston, N. 2003. Overview: equity valuation in a global context. AIMR conference
proceedings, April. CFA Institute:1-4.
Sliwoski, L.J. 1999. Alternatives to business valuation rules of thumb for small businesses.
The National Public Accountant:1-4.
Smith, V.K. & Goudzwaard, M.B. 1970. Survey of investment management: teaching and
practice. Journal of Finance 25:329-347.

134 Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135

 Nel

Triantis, A. 2005. Realizing the potential of real options: does theory meet practice?
Journal of Applied Corporate Finance 17(2):8-16.
Upton, R.M. 1949. Conference on the teaching of business finance. Journal of Finance 4:
summary statement.
Volker, H. & Richter, F. 2003. Pricing with performance-controlled multiples.
Schmalenbach Business Review 55:194-219.
Wendt, P.F. 1966. What should we teach in an investment course? Journal of Finance
21:416-422.
Wetherilt, A.V. & Weeken, O. 2002. Equity valuation measures: what can they tell us?
Bank of England Quarterly Bulletin:391-403.

Annexure A
Acronym/Abbreviation Description
CI Capital invested
D Dividend
DCF Discounted cash flow
DGM Dividend growth model
DYM Dividend yield model
EBITDA Earnings before interest, tax, depreciation and amortisation
EPS Earnings per share
ε (Dt) Expected dividend in year t
ε (Et) Expected earnings in year t
EVA Economic value added
EYM Earnings yield model
FCF Free cash flow
FCFE Free cash flow to equity
FCFF Free cash flow to the firm
g Expected growth rate in perpetuity
NAV Net asset value
P/E Price/earnings
PwC PricewaterhouseCoopers
Re Cost of equity
ROI Return on investment
RoR Required rate of return
ROT Rule of thumb
SAICA South African Institute of Chartered Accountants
TV Terminal value
V0 Value of a share in the current time period
WACC Weighted average cost of capital

Meditari Accountancy Research Vol. 17 No. 2 2009 : 117-135 135