Is There A Limit To The Accuracy of Equity Valuation Using Multiples?

Is there a limit to the accuracy of equity valuation
using multiples?*
Ian A Cooper
London Business School
Sussex Place
Regent’s Park
London NW1 4SA
United Kingdom
+44-2070008259
icooper@london.edu
Neophytos Lambertides
Cyprus University of Technology
Department of Commerce, Finance and Shipping
140 Ayiou Andreou Street
P.O.Box 50329
3603 Lemesos
Cyprus
n.lambertides@cut.ac.cy
Version 6
January 2014
Abstract
We investigate the reasons for there being an apparent limit to the accuracy of valuation
using multiples, when it is implemented in a standard way. We find that most of the
error comes from failing to correct known biases in earnings forecasts. Another part
comes from mismatching observable characteristics of target firms but the only
characteristic that matters is growth. A smaller part comes from mismatching
unobservable but persistent characteristics of the target firm. We develop a procedure to
eliminate these errors, which reduces the variance of valuation errors by more than 60%.
The remaining error is mainly random noise.
JEL Codes: G11, G24, D81.

Keywords: Equity Valuation; Valuation; Multiples Valuation.
*We are grateful to participants in seminars at KU Leuven, and to Scott Richardson and
Piet Sercu for helpful comments and suggestions. All remaining errors are our own.
Electronic copy available at: http://ssrn.com/abstract=2291869

1. Introduction
Although the use of multiples is widespread in financial analysis books (Damodaran

(2002), Healy and Palepu (2007)) and also common in practice (Baker and Ruback
(1999), Block (2010)), studies of equity valuation using multiples report significant
errors even when the best from a range of methods is used to select the value-driver. For
example, the classic study by Liu, Nissim, and Thomas (2002) reports a minimum
standard deviation of the valuation error of 28.3%. This is the error for the best value-
driver (forward earnings) from a set of 17, which includes the value given by the
residual income model. In this study we seek to understand whether this error can be
reduced by alternative ways of implementing valuation using multiples.
We first test whether improved matching of the observable characteristics of the target
firm increases the accuracy of valuation. To implement this test we develop a simple
characterization of multiples-based valuation as a procedure for matching the
characteristics of the target firm with a portfolio of comparable firms. The approach is
based on the idea that a firm should have the same value as a portfolio that replicates its
value-relevant characteristics. The price of this replicating portfolio can be expressed as
the weighted average of multiples of the comparable firms included in the matching
portfolio.
The model implies that the weight given to a comparable firm should be proportional to
the inverse of a linear index of the differences between its value-relevant characteristics
and those of the target firm. Given that comparables are chosen from the same industry
as the target, we find that the only important characteristic in this weighting is the long
term growth forecast. Weighting by the inverse of the difference between the growth
rate of the target and comparable firm is at least as good as other weighting schemes, in
the sense that matching other characteristics does not increase valuation accuracy. Using
this weighting scheme improves valuation accuracy a little relative to not weighting.
We then examine the time-series behavior of valuation errors and identify a strongly
persistent component. The error in a multiples-based valuation in one year predicts a
large part of the error for the same firm in the following year. We used the lagged error

to improve accuracy by allowing for this persistent component. This results in a large
improvement in accuracy.
We next use the procedure of Mohanram and Gode (2013) to remove known biases from
earnings forecasts before using multiples. We find that this results in a further
substantial improvement in valuation accuracy. Using a common sample the
combination of the improved weighting scheme, lagged error adjustment, and earnings
bias adjustment reduces the standard deviation of the valuation error from 31.9% to
19.6%. Thus we remove 62% of the variance of the valuation errors. We find that much
of the persistent valuation error is eliminated by using the corrected earnings forecasts.
Finally, we test whether allowing the choice of value driver to vary by industry and year
improves the accuracy of valuation. We find a high degree of instability in the optimal
multiple in different industries which negates this as a means of improving accuracy.
The study proceeds as follows. We summarize the literature and develop the model. We
confirm that there is a limit on the accuracy of valuation using multiples, if it is
implemented in standard ways. We then test whether the errors in multiples-based
valuation are caused by: (1) the choice and weighting scheme for peer companies, (2)
mismatching the characteristics of the target firm, (3) omitted characteristics, (4)
earnings biases, (5) different value-relevance of different multiples in different
industries and over time, or (6) random errors. We show the implications of our findings
for improving the accuracy of valuation using multiples.
2. Prior research
We build on two strands of the literature concerning valuation using multiples. One is
the relatively small literature that examines the theoretical underpinnings of multiples as
a valuation procedure. The other is the more extensive literature on the accuracy of
multiples-based valuation.
There is no generally accepted theory of valuation using multiples. Many studies do not
give a formal motivation, presenting the method as an ad hoc procedure. Those studies
that do give a theoretical justification fall broadly into two types. One approach that is

similar to the model developed here is to postulate a linear relationship between value
and a “value driver” such as earnings. From this it is possible to derive a valuation
approach based on multiples (Baker and Ruback (1999), Liu, Nissim, and Thomas
(2002)). The difference from the approach followed in this study is that those studies
posit directly a linear statistical relationship between value and a value-driver. In this
study we derive the relationship from a replication argument that is similar in spirit to
the replication procedure in Boatsman and Baskin (1981). The linear relationship
between value and the value-driver is a consequence of matching the value-relevant
characteristics of the target firm with the characteristics of a replicating portfolio of
comparable firms. This is similar to the linear value-driver approach, but it gives a
specific implication regarding the weighting of comparable firms.
The other theoretical approach that has been used to justify valuation using multiples is
to linearize (either explicitly or implicitly) a DCF-based model such as the constant
growth model or the residual income model. For example, Bhojraj and Lee (2002) use a
version of the residual income model to derive a list of variables that should affect
equity valuation. They then use these variables in a cross-sectional linear regression with
the multiple as the independent variable. This approach assumes a linear relationship
between the multiple and the independent variables, with constant coefficients across the
entire set of firms used in the regression. That assumption is a shortcoming of the
approach because such relationships are not necessarily linear, especially when applied
across the whole universe of firms.
The second area of the literature on which we draw is empirical studies investigating the
accuracy of multiples-based valuation of share prices. The most comprehensive
investigations of this issue are the classic studies of Liu, Nissim, and Thomas (2002)
(“LNT”) and Bhojraj and Lee (2002) (“BL”).
LNT use a sample of firms listed on NYSE, AMAX, and NASDAQ in the period 1982-
99. The study examines the accuracy of multiples-based valuation of equities using 17
value-drivers including earnings forecasts, cash flow, book value, sales, and 3 simple
implementations of the residual income model. The restrictions on the sample include
trimming at the 1% and 99% of every value-driver, requiring all value-drivers to be
positive, requiring earnings forecasts and long-term growth to be available on IBES, and
4
other data availability restrictions. These restrictions result in a sample of between 11%
and 18% of the population by number of firms, depending on the year. The best
valuation procedure of the 21 examined gives a standard deviation of the valuation error
equal to 28.3% over this restricted sample. That procedure is to use 2-year forward
earnings as the value-driver and take the harmonic mean of all comparable firms in the
same IBES industry.
Interestingly, this simple procedure is more accurate than using other methods that are
often considered superior. For example LNT report a standard deviation of 64.5% using
EV/EBITDA, and 35.1% for the best of 3 alternative implementations of a relatively
sophisticated transformation of data based on the residual income model. It remains an
open question why the use of the P/E ratio outperforms these theoretically superior
models, but in this study we use price-to-forward earnings as the method that has been
found to be most accurate in the definitive study by LNT.1
A standard deviation of 28.3% is a significant valuation error for a sample where the
value-driver has been chosen to minimize the valuation error, hard-to-value companies
have been omitted, the data has been truncated, and the residual income model has been
included as a value-driver. In comparison, BL report mean absolute valuation errors of
57% based on Enterprise Value to Sales (EVS) and 44% based on Price-to-book (PB).
Their sample is less truncated and they examine 3 different valuation procedures for
each value-driver.
BL select comparable firms using the fitted value of a regression of multiples on 8

independent variables (the “warranted multiple”). The information contained in the
warranted multiple includes the industry average multiple as well as profit margins,
growth rates, leverage, return on equity, and R&D all relative to the industry average.
The comparable firms are the 4 closest based on the warranted multiple. BL find that
this procedure is more accurate than using a fitted multiple based on the previous year’s
regression. So despite the large amount of information in the warranted multiple it is not
used beyond being the criterion for the selection of comparable firms. Our results echo
1
We conducted a preliminary test using our data sample and confirmed the superiority of the P/E multiple
to multiples of book value, cash flow from operations, earnings excluding extraordinary items, EBITDA,
and sales.
5
this finding, in that we also find instability of the coefficients of multiples on
characteristics to be a factor limiting the accuracy of multiples-based valuation.
Other studies have examined what averaging procedure to use and how to choose
comparable firms (Boatsman and Baskin (1981), Alford (1992), Bhorjaj and Lee (2002),
Liu, Nissim, and Thomas (2002), (2007)). Kim and Ritter (1999) study the use of
multiples in valuing IPO’s. DeFranco et al (2012) examine the selection of comparable
firms by analysts and show that they use samples with biased growth rates, on average.
Kaplan and Ruback (1995) examine the accuracy of multiples-based valuation for a
relatively small sample of LBO’s and find that it can be as accurate as DCF and also
contains information complementary to the information in a DCF valuation.
3. A model of valuation using multiples
In this section we develop our procedure for multiples-based valuation. The approach is
an extension of the linear value-driver approach of Baker and Ruback, which is also
used by LNT. The valuation procedure is derived from the idea of replicating the
characteristics of the target firm with a portfolio of comparables, and is similar in spirit
to Boatsman and Baskin (1981). The characteristics could include current and future
earnings, dividends, beta, book value, past return history, past cash flow history (as in
Boatsman and Baskin) and future cash flow. The only restriction in the way that we
develop the procedure is that the characteristics must combine linearly in a portfolio.
The assumption that characteristics combine linearly in portfolios is less restrictive than
it may seem. Some value-drivers, such as beta, are intrinsically linear. Others may
appear non-linear but will be linear if the replication is complete enough. For example, if
the replicating portfolio matches the current level of earnings of the target firm as well
as the future level of earnings it will replicate the forecast growth rate. Also, if the
replicated characteristics include both dividends and earnings the procedure will
replicate the pay-out ratio of the target firm. Similarly, if it replicates book value and the
earnings forecast it will replicate prospective ROE. In this way, most value-relevant
characteristics are linear in the sense required by the procedure. Even characteristics
such as liquidity are linear if a factor representation such as Acharya and Pedersen (2005)
is used.
6
To illustrate how this approach gives rise to a valuation procedure that uses multiples,
suppose that the company to be valued has a constant growth rate, zero debt, and an
equity beta of 1. Suppose that it will generate $X0 of free cash flow next year and the
CAPM holds. Then we could value the company by DCF using the constant growth
formula:
P = X0/(K - g) (1)
Where P is the value of the share, K is the discount rate, and g is the perpetual growth
rate. Suppose that the value of K is unknown because the equity market risk premium is
unknown. Since the CAPM is known to hold it is possible to select a portfolio of firms
that have the same value of K as the target firm by making the beta of the replicating
portfolio the same as the beta of the target share.
Denote the firm to be valued as T (the target firm) and assume that there are two
comparable firms i=1,2. Suppose that all three firms have the same beta, and so have the
same unobservable K. Then the only characteristics that are relevant to the relative
valuation of these three firms are the current level of cash flow per share and the forecast
level of growth. Define the growth rate by the ratio of the expected cash flow in some
future year H, XH, to the current cash flow, X0.
Construct a portfolio by investing Wi dollars in each of the comparable firms so that the
Wi satisfy the following:
X 0T  W1 X 01 / P1  W2 X 02 / P2 (2)
X HT  W1 X H 1 / P1  W2 X H 2 / P2 (3)
Where Pi is the price of share i. These equations say that the portfolio replicates the
characteristics {X0T, XHT} of the target firm. The cost of the replicating portfolio is the
estimated value of share T:
PˆT  W1  W2 (4)
Equation (4) thus gives the estimated value of the target share. This procedure has
similarities to sum-of-the-parts valuation, which assumes that portfolios of pure play
firms may be used to replicate the characteristics of a conglomerate firm (e.g. Cohen and
Lou (2012)).
7
This procedure may be characterized as a multiples-based valuation in the following
way. Define wi  Wi / (W1  W2 ) . Dividing equation (3) by (4) gives:2
X 0T / PˆT  w1m1  w2 m2 (5)
Where mi  X 0i / Pi is the cash-flow-to-price multiple of firm i (i.e. the inverse of the

price-to-cash-flow multiple). Equation (5) is a multiples-based valuation of the target
firm, T. The estimated multiple is a weighted average of the cash flow-to-price multiples
of the comparable firms. Using a related approach Baker and Ruback (1999) and Liu,
Nissim, Thomas (2002) derive an unweighted version of Equation (4). Rather than a
weighted average, they use the unweighted average earnings-to-price multiple of
comparable firms (i.e. the harmonic mean of P/E ratios).
Equations (2) and (3) can be solved to give the weights wi to use in Equation (5).
Appendix 1 analyzes the general case and shows that the weights wi should be chosen to
satisfy:
wi  1/ ABS (di ) (6)
Where di is a measure of the “distance” between firm i and the target firm based on the
difference between their future earnings expectations. Each comparable firm’s
earnings/price multiple should be given a weight proportional to the inverse of this
measure of its difference from the target firm. Note that this derivation of the multiples
approach does not require knowledge of the market risk premium. A similar observation
is made by Baker and Ruback (1999).
The measure of difference between the target and comparable firm used to determine the
weighting of the comparable firms could be a single characteristic, such as growth, as in
the above example. Alternatively it could be an index of several characteristics, as in the
“warranted multiple” of Bhojraj and Lee (2002). All that is required for the approach to
work is that the characteristics combine linearly in portfolios, as in equations (2) and (3).
The characteristic used as the basis of the multiple could be cash flow, earnings, book
value, or revenue. In the empirical tests below we use 1-year forward earnings. This has
been found empirically by LNT to give the most accurate valuation and has a clear
2
The LHS of (2) is divided by the LHS of (4) and the RHS of (2) by the RHS of (4).
8
theoretical motivation in the work of Ohlson (1995) and Ohlson and Juettner-Nauroth
(2005). However, we also test whether using other value-drivers can improve valuation
accuracy.
4. Data
For the period 1982-2010 we merge accounting numbers from COMPUSTAT; price,
analysts’ forecasts and actual earnings per share from IBES, and stock returns from
CRSP. As of April each year we select firm years that satisfy: (1) COMPUSTAT Sales
(item #12) is non-missing and greater than $100 million for the previous fiscal year; (2)
price, actual EPS, forecasted EPS for years (t+1) and (t+2), the long term growth
forecast, and the number of following analysts are available in the IBES summary file;
and (3) the price to earnings forecast for (t+1) ratio is positive and lie within the 1 st and
99th percentiles of the pooled distribution. In addition, (1) the share price is greater than
or equal to $2; and (2) each industry-year combination has at least 5 observations. The
resulting sample has 39,872 firm-year observations between 1982 and 2010, compared
with LNT’s sample of 19,879 observations between 1982 and 1999, and with BL’s
sample of 19,187 observations between 1982 and 1998. Using the LNT sample
restrictions over our period results in 35,690 observations and BL restrictions give
30,111 observations over our period.3
In the test of valuation accuracy we show how the results based on our sample compare
with those generated using the sample selection procedures of LNT and BL. They
constrain their samples in different ways. LNT have the most restricted sample,
requiring that the ratio of price to value-driver lies within the 1st and 99th percentiles of
the pooled distribution for 13 other value drivers that they test. The BL sample is a little
more restricted than ours because it requires the availability of data to calculate a
regression estimate of the fitted multiple.
In detail the LNT sample selection procedure is: (1) COMPUSTAT data items 4, 5, 12,
13, 25, 27, 58, and 60 are non-missing for the previous fiscal year (year t); (2) at least 30
monthly returns (not necessarily contiguous) are available on CRSP from the prior 60
3
BL also include the restriction that Sales>$100 million, but to be consistent with LNT we do not use that
restriction.
9
month period; (3) price, actual EPS, forecasted EPS for years t+1 and t+2, and the long
term growth forecast are available in the IBES summary file; and (4) all price to value-
driver ratios for 14 multiples examined by LNT lie within the 1st and 99th percentiles of
the pooled distribution, (5) share price on the day IBES publishes summary forecasts in
April is greater than or equal to $2; (6) all multiples are positive; and (7) each industry-
year combination has at least five observations.
The BL sample selection procedure is: Share price on the day IBES publishes summary
forecasts in April is greater than or equal to $3; and COMPUSTAT Sales is greater than
$100 million. Firms with negative book value (defined as common equity), and any
firms with missing price or accounting data needed for the warranted estimation
regression are eliminated. All variables lie within the 1st and 99th percentiles of the
pooled distribution. Each industry-year combination has at least five observations. In our
analysis we omit the restriction on sales.
Table 1 shows summary statistics for the three samples selected over the common period
1982-2010. The standard deviation of the P/EPS1 multiple is 11.32 on our sample, 10.33
using the LNT sample selection procedure, and 11.04 using the BL sample selection
procedure. Thus the LNT restrictions are somewhat reducing the variability of the
multiples in the pooled sample, consistent with the reduction of the number of firm-year
observations from 39,872 to 30,111.
5. Valuation accuracy
5.1 Choice of comparables and weighting scheme
The valuation model we have presented results in a procedure whereby comparable

firms are weighted by the inverse of their “distance” from the target firm. The measure
of distance could be any index of value-relevant characteristics. In this section we test
whether using such a weighting scheme improves on the procedures found to be optimal
by LNT and BL. We compare inverse distance weighting with the industry average
procedure of LNT and the use of 4 comparables chosen on the basis of the warranted
multiple, which is found to be optimal by BL. We use forward earnings as the value-
10
driver, which LNT found to be optimal. BL use sales and book value as their value-
drivers, but LNT find these to be less accurate than forward earnings.
We define the valuation error for firm i at time t by:
VEit  ( Pit / Pît )  1  (M it / Mˆ it )  1 (7)
Where Pit is the price of share i at time t, Pît is the estimated price of share i at time t,
M it is the P/EPS1 multiple of share i at time t, and Mˆ it is the estimated P/EPS1 multiple
of share i at time t.
Table 2 shows the comparison. The three panels test the relative accuracy of different
procedures using the three sample selection procedures. Hence each panel gives a fair
comparison of accuracy conditional on the sample chosen. In each panel the first two
rows (sub-panel 1) follow the procedures found to be optimal by LNT and BL. LNT use
the harmonic mean of all firms in the same industry as the target firm. BL use the
harmonic mean of the 4 closest firms by their warranted multiple measure. The numbers
in the table differ from those found by LNT and BL because the sample period is
different to theirs. Also, in the case of BL, a different value-driver is used. BL use book
value and sales as their value-drivers, whereas we use forward earnings.
The other 3 sub-panels show different sample choices and weighting schemes. Where
inverse distance weighting is used the weights are based on the measure indicated in
each panel.4 Sub-panel 2 uses raw earnings growth to select and weight the comparable
firms. Sub-panel 3 uses industry-corrected earnings growth, and sub-panel 4 uses the
warranted multiple measure of BL. The difference between using earnings growth and
industry-corrected earnings growth is slight and results from slightly different data
availability for the two measures.
There are several important features of Table 2. First, measuring accuracy by the
standard deviation of the valuation error the best procedure in each panel is to use all
4
To avoid singularity resulting from two firms having equal growth rates and a distance measure of zero a
very small constant, equal to 1 basis point, is added to the distance.
11
firms in the industry weighted by the inverse distance measured using growth rates.
Second, in no panel is the warranted multiple found to be the best approach, whatever
the criterion of accuracy. Using growth as the single characteristic is at least as good as
the much more sophisticated measure of BL. This is surprising, since it implies that
matching by the broad set of characteristics contained in the warranted multiple is
relatively unimportant once the target firm and replicating portfolio have been matched
by industry and growth rate. To be fair to BL, their method was not designed to give
maximum valuation accuracy using contemporaneous multiples. Rather it was designed
to give better predictive multiples.
Third, although the inverse distance weighting scheme improves the accuracy of the
valuation, by far the most striking feature of Table 2 is that the standard deviation of the
valuation errors is greater than 30% for every method. There appears to be a limit to the
accuracy of valuation using multiples when it is implemented in this way. The relative
sophistication of the inverse distance weighting scheme increases accuracy, but only a
little when compared with the LNT method of using the unweighted harmonic mean of
all firms in the same industry as the target. Even with the LNT sample selection criteria,
which severely restricts outliers, the standard deviation of the valuation error is still
greater than 30% regardless of the method used.
We interpret this result as indicating that valuation using multiples implemented in this
way has a limit on its accuracy, and is subject to significant errors regardless of the
approach used. Although LNT conclude that “.. multiples derived from forward earnings
explain stock prices remarkably well: pricing errors are within 15 percent of stock prices
for about half our sample.” we focus on the remaining valuation error, which has a
standard deviation of more than 30% in our sample.
The errors in Table 2 could come from several sources: (1) mismatching between value-
relevant observable characteristics of the target firm and the portfolio of comparables; (2)
mismatching between unobservable value-relevant characteristics of the target firm and
the portfolio of comparables; (3) persistent valuation discrepancies; (4) biases in
earnings forecasts; (5) random valuation discrepancies. Each of these has different
implications for the implementation of multiples-based valuation. The first four would
12
imply that valuation using multiples could be improved by adjusting for them. Random
errors would suggest that there is a limit to accuracy, whatever procedure is used.
In the remainder of the paper we investigate which of these is the source of the limit on
the accuracy of multiples-based valuation and develop the implications for valuation and
predicting returns and earnings. To implement the tests we use the unweighted harmonic
mean of the P/EPS1 ratio of all firms in the industry and also the weighted harmonic
mean with weights proportional to the inverse of the difference between the long-term
growth rates of the target and comparable firms. These are the approaches found to give
the most accurate valuations in Table 2.
5.2 Mismatching of characteristics
It is possible that the cause of the valuation errors is mismatching of the characteristics
of the target firm and replicating portfolio (DeFranco et al (2012), Holthausen and
Zmijewski (2012)). To test this we regress the valuation error on the difference between
the characteristic of the target firm and that of the replicating portfolio. We examine the
relationship between valuation errors and the difference in characteristics between the
target firm and the portfolio represented by the multiple valuation. For characteristic j
and target firm T this difference is measured as:
ΔCT,j= CT,j - w
i
T ,i Ci , j (8)
Where CT,j is the value of characteristic j for firm T, wT,i is the weight given to
comparable firm i in the estimated multiple for firm T, and Ci , j is the value of
characteristic j for firm i. We include both the characteristics used to select comparable
firms in Table 2 (the growth rate and the warranted multiple) and other characteristics
that may be value-relevant: size measured by market value of equity, dispersion of
analysts’ forecasts, payout ratio, and beta.
For each year, and for the pooled sample, we run a regression of the valuation error of
target firm T on the differences between its characteristics and the portfolio of
comparable firms used in its valuation:
13
VET = a +  b C
j
j T,j + eT T=1, 2, … NT (9)
Table 3 reports the results. Size differences between the target and comparable firms
have an insignificant impact. The most significant characteristic is growth, which
reinforces the results found in Table 2. Payout, dispersion of analysts’ forecasts, and
beta are also significant, but have a very limited effect. We also tested the effect of
mismatching the loadings on the Fama-French HML and SMB factors, but these were
insignificant.
For the pooled sample, the adjusted R2 using the unweighted multiple is 8.37% with
growth alone and 10.45% when the other variables are included. For the weighted
multiple the R2 using only growth as an independent variable is 3.42% and it is 6.01%
with the other variables included. Including the difference in the warranted multiple
between the target firm and the replicating portfolio does not result in a significant effect.
The warranted multiple results are not reported in the table because they impose
additional sample restrictions on data availability.
The weighted multiple seems to do a better job of matching characteristics, giving only
6.01% R2 between valuation errors and differences in characteristics, compared with
10.45% for the unweighted multiple. However, although the inverse distance weighting
scheme is designed to give good matching of the characteristics of the target firm and
replicating portfolio, it has not given exact matching. To impose that condition on the
growth rate there would need to be an equal number of firms that have higher and lower
growth than the target firm. That is not possible. For example, if a firm has the highest
growth rate in an industry it is not possible to match that growth rate with a portfolio
that has only positive holdings in other firms.5
As a further test of the relevance of these omitted characteristics we examine the

reduction in valuation errors that can be achieved by knowing the differences in
characteristics between the target firm and the portfolio of comparables. To implement
the test in a way that allows for instability in the coefficients of regression equation (9)
5
It is possible to match the growth rate if negative holdings are allowed in the replicating portfolio, but
that introduces other issues.
14
we calculate an adjusted multiple estimate using lagged coefficients to give an adjusted
valuation error for target firm T at time t:
VET ,t  VET ,t  at 1   b j ,t 1CT , j ,t (10)

j
Where VET ,t is the valuation error for target firm T at time t, at 1 and b j ,t 1 are the
coefficients of regression (12) estimated at time (t-1), CT , j ,t are the differences in
characteristics for target firm T measured at time t.
Table 4 shows the accuracy of these adjusted estimates. The improvement over the
unadjusted estimates is small. The standard deviation of the valuation error using the
weighted multiple improves from 35.76% to 34.16%. The small improvement in
valuation accuracy is greater in the case of the unweighted multiple, because that does
not match the characteristics of the target firm as well as the weighted multiple. The
limited increase in accuracy is partly because the R2 of the regressions in Table 3 is quite
low, but it is also because the coefficients on the characteristics are unstable. This
echoes the result found by BL that using the lagged warranted multiple does not increase
valuation accuracy.
Finally, we tested how much of the valuation error could be explained by governance
differences between the sample and comparable firms. For those years where the
Gompers et al (2003) governance index is publicly available (1998, 2000, 2002, 2004,
2006) we divided firms into 3 groups (“democratic”, “dictatorship” and other) based on
their classification. This gives a sample of 1200 firms (the “governance sample”). We
measured the average valuation error for the three groups and found that only the
democratic portfolio shows a significant error, undervaluing the target firm by an
average of 7.1%. The average errors in the other two groups are insignificant. We then
incorporated a governance adjustment into our valuation procedure by adjusting the
value estimate for the democratic group by the average valuation error from 2 years
before. This improves the accuracy of valuations of the governance sample only
marginally, largely because there are only 96 democratic firms so that even though the
adjustment is significant for them it does not improve the accuracy much across the
entire sample.
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These results suggest that very little of the valuation error is related to differences in
observable characteristics between target firms and the portfolio of comparable firms.
The characteristics we have tested include size and payout, and also characteristics such
as profit margins, growth rates, leverage, return on equity, and R&D which are included
in the BL warranted multiple. Since the difference in size between the target and
comparable firms does not explain the valuation errors they are highly unlikely to be
caused by any characteristic that is related to size, such as illiquidity effects (Amihud
(2002)). Similarly we can exclude cost of capital premia related to size. Also, the cause
cannot be a characteristic that has a constant effect on multiples within an industry
because the valuation error is the difference between multiples of firms within the same
industry.
Put differently, the valuation procedures seem to do a good job of matching observable
value-relevant characteristics. The reason for this is that all the methods examined in
Table 2 use only firms from the same IBES industry. The result is consistent with Alford
(1992), who has shown that once industry is controlled for characteristics such as growth
and risk play only a marginal role in improving multiples-based valuation.
5.3 Omitted but persistent characteristics
There may be value-relevant characteristics that are not included in the above regression.
If this is the case and the omitted characteristics are persistent, we expect the valuation
errors to be persistent.6 A firm that has a high value relative to its comparable peers in
one period will, if the omitted but unobservable difference in characteristics is persistent,
also have a high valuation error in the subsequent period. To test whether this is a cause
of the valuation errors we regress the valuation error in one year on its lagged value:
VEi,t = a + b*VEi,t-1 + ei,t (11)
Table 5 reports the result of this regression.7
6
More precisely, the valuation errors will be persistent if the difference between these characteristics for
the target and matching portfolio is persistent.
7
We also ran the regressions with controls for the differences in characteristics. The results were not
significantly different.
16
The average R2 of the pooled regression is 39.95% for the unweighted multiples and
34.88% for the weighted. The high R2 indicates that there is a significant persistent
component of the valuation error. This must represent a persistent difference in some
value-relevant characteristic between the target firm and the portfolio of comparable
firms. As discussed in the previous section, this persistent characteristic cannot be
something that is constant within an industry or any of the observable characteristics
tested in the previous section. The regression using weighted multiples is better than that
using unweighted multiple. It has a lower R2, indicating less omitted persistent error, and
its constant term is insignificantly different from zero, whereas the constant in the
regression using unweighted multiples is significant. Including the differences in
characteristics between the target and comparable firms adds little to this regression,
increasing the R2 of the two regressions to 41.44% and 35.87% respectively.
The persistence of the errors suggests that valuation accuracy can be improved by using
information from past errors. To do this we adjust the estimated price at time t by the
predicted valuation error determined by the valuation error at time (t-1) combined with
the coefficient from regressing the valuation error at time (t-1) on the valuation error at
time (t-2). Table 6 shows the result. The standard deviation of the valuation errors is
now reduced below 30% for the first time. The persistence of valuation errors allows the
accuracy of multiples-based valuation to be significantly improved. However, this
depends on being able to observe the valuation error at time (t-1) and so would not be
possible for private company valuation unless a transaction had recently occurred.
Despite the large improvement, a significant error remains. There is a component of the
error in a multiples-based valuation that is unrelated to observable characteristics or
persistent unobservable characteristics. The standard deviation of this component is
approximately 27% (the remaining valuation error in Table 6). Furthermore, adjusting
using lagged valuation errors cannot be used to improve the accuracy of valuation of
private firms or firms in IPO’s because the prior valuation error is not observable.
Therefore, we investigate the degree to which this persistent error can be eliminated by
correcting earnings forecasts for known biases.
5.4 Biases in earnings forecasts
17
The procedures tested so far all use unadjusted earnings forecasts (recent articles
studying this include Hughes et al (2008), Larocque (2013), and Mohanram and Gode
(2013)). However, there are known biases in earnings forecasts that can be corrected by
using a combination of other firm characteristics as instruments. Since valuations should
depend on unbiased forecasts we examine whether correcting earnings forecasts for
known biases before implementing a multiples-based valuation improves its accuracy.
To implement the correction, we use the linear relationship between earnings bias and
accounting variables given in Mohanram and Gode (2013) table 6 panel B. This gives
the predictable error in the earnings forecast as a linear function of the lagged values of
accruals, sales growth, long-term growth estimate, growth in PPE, growth in other long
term assets, 12 month stock market return, and the revision in analysts’ earnings
forecasts. Table 7 shows the effect on valuation accuracy of using the adjusted earnings
forecasts, as well as combining this with the weighting of comparables and adjusting for
lagged valuation errors. The availability of data for the Mohanram and Gode adjustment
restricts the sample, so the table is constructed using a common sample.
If unadjusted earnings are used with no weighting of comparables and no adjustment for
lagged errors, the standard deviation of valuation errors is 31.89% Using adjusted
earnings forecasts and weighting reduces the SD to 23.10%, approximately halving the
variance of errors. Thus, even for firms which have no prior valuation errors on which to
base the lag adjustment, much of the valuation improvement can be achieved by using
the earnings adjustment and the weighting scheme. Including the lagged valuation error
reduces the SD further to 19.63%. The total reduction of the variance from including all
three adjustments is more than 60% (from a SD of 31.89% to 19.63%). The
improvement in the interquartile range is even better than the improvement in the
standard deviation, from 33.43% to 18.12%, suggesting that the method is particularly
useful in eliminating outliers.
5.5 Industry-specific multiples
LNT discuss the possibility of using value-drivers that are different for different
industries. To test whether this can improve the accuracy of valuations we performed the
18
following test. For each industry-year we measured the standard deviation of the
valuation error resulting from using each of the Price-to-earnings (PE), Price-to-book
value (PB), or Enterprise value to sales (EVS). We selected the multiple that had the
lowest standard deviation and then used that as the valuation procedure for the following
year. Figure 1 shows the frequency with which the 3 multiples were ex post optimal
across the 72 industries by year. For all years using the PE ratio was optimal ex post in
the majority of industries. Only in the internet bubble years between 1998 and 2004 and
the credit crisis years between 2008 and 2010 were the other methods optimal in a
significant number of industries.
Table 8 shows the 1-year transition matrix between optimal methods. Even when a
method other than PE is optimal in one year it is still likely that PE will be the optimal
method for that industry in the following year. For example, conditional on PB being
optimal for an industry at time t the probability of PE being optimal at time (t+1) is
60.3%. Thus the optimal method (other than PE) is unstable. As a consequence, the
overall accuracy of the procedure where the prior year’s optimal method is used is only
37.92% standard deviation. This may be compared with the standard deviation of
35.38% that results from always using the PE ratio.8
6. Predictability
6.1 Predictability of valuation errors and stock returns
The constant term in the regression of the valuation error on its lagged value is 0.61,
implying that the valuation error decays by about 40% per year. A coefficient less than
1.0 means that the change in the valuation error is predictable based on its lagged level,
as the multiple of the target firm converges to the multiple of the replicating portfolio.
Predictable convergence of valuation errors has been used to examine the properties of
different valuation models and to predict returns (for example Gatev et al (2006) for
equities and Correia et al (2012) for bonds). In this section we examine the implication
of the predictable convergence of the multiples of the target and replicating firms.
8
In a somewhat related result, Chang et al (2011) find that selecting the best implementation of residual
income valuation ex ante is also difficult.
19
Appendix 2 shows that the log of the rate of return can be decomposed into four
components:
ln( Rt 1,t )  LVEt 1,t  ln(Mˆ t / Mˆ t 1 )  ln( Et / Et 1 )  ln[( Pt  Dt ) / Pt ] (12)
Where Rt ,t 1 is the rate of return between t and (t+1), LVEt 1,t is the change in the log
valuation error defined as LVEt 1,t  LVEt  LVEt 1 , LVEt  ln(M t / Mˆ t ) , Mˆ t is the
fitted multiple at date t, M t the actual multiple at time t, Et is the one-year earnings
forecast at time t, Pt is the price at time t, and Dt is the dividend paid between (t-1) and
t.
Table 9 shows the result of regressing these four components of the rate of return on the
lagged valuation error, as well as the regression of the rate of return on the lagged
valuation error. The first term of Equation (12), the change in the log valuation error, is
predictable based on the level of the valuation error. The R2 of this regression is
21.434% with the unweighted multiples and 23.70% with the weighted. Comparing the
weighted multiple with the unweighted, the mean-reversion of the weighted multiple is
faster and its R2 higher, indicating that it gives a better measure of value over time as
well as at a point in time.
The valuation error mean-reverts towards zero, so a high valuation error at the start of
the year predicts a fall over the year. If nothing else happened, this would predict a
negative rate of return. However, the return itself is hardly predictable at all, with an R 2
of just 2.43% unweighted and 1.98% weighted. The reason is that a high valuation error
also predicts two other important components of the return. A high valuation error
predicts that the fitted multiple will rise, as shown by the second regression in each
panel. It also predicts that the earnings forecast will be revised upwards during the year,
as shown by the third regression.
Thus a high valuation error predicts upward revision in earnings forecasts, and also
predicts that the closest comparable firms next year will have higher multiples than
those this year. Hence the current share price reflects a part of fundamental value
(revisions in earnings forecasts and revisions in multiples of comparable firms) that is
not captured by using multiples-based valuation. However, a high valuation error does
20
not predict a low rate of return because the current market price is efficient with respect
to the predictable revision of the valuation error. There is also a large remaining
component of the valuation error that appears to be random noise which regenerates
from period to period.
6.2 Predictable revisions in earnings forecasts
The valuation error predicts 3.48% of the variance of the revision in 1-year earnings
forecasts, even after the Mohanram and Gode correction has been made. Thus valuation
errors from multiples-based valuation can be used to improve earnings forecasts
incrementally to the variables included in the Mohanram and Gode procedure.
6.3 Extensions
Although the primary focus of this paper has been on diagnosing the reasons for the
apparent limit on the accuracy of valuation using multiples, we believe that more
detailed investigation using the framework we have developed offers several interesting
areas for future research. First, our model gives a framework for valuation using
multiples based explicitly on replication of multiple characteristics of the target firm
with a portfolio of comparable firms. We have investigated some properties of particular
valuation procedures that correspond to particular ways of building replicating portfolios.
One of the most surprising results is that matching only a few characteristics of the
target firm is better than matching many characteristics. Understanding why this is the
case could give important insights into asset pricing. Second, identification of the
unobservable characteristics causing persistence in valuation errors would give insight
into value-relevant characteristics not captured by standard approaches to valuation
using multiples. Some candidates for this analysis are governance variables, and risk
proxies such as operating leverage. Third, deeper understanding of the dynamics of
relative valuation errors may lead to insights about how market prices and fundamental
values are related. Our interpretation of valuation using multiples as a replication
procedure means that the behaviour of relative valuation errors can be directly linked to
portfolio strategies. Finally, explaining cross-sectional differences in the volatility of
relative valuation errors using variables such as trading volume or sentiment variables
may assist in understanding what factors generate random noise in relative valuations.
21
7. Conclusions
We have developed a new theory of equity valuation using multiples, based on

replicating multiple characteristics of the target firm with a portfolio of comparable
firms and used it to examine whether there is a limit on the accuracy of such valuations.
The procedure requires only that value-relevant characteristics combine linearly in
portfolios. Almost all important characteristics can be expressed in a way that satisfies
this condition. The theory gives a prediction about the weighting of comparable firms
that should be used in a multiples-based valuation. The harmonic mean of comparable
firms should be weighted by the inverse of the difference between an index of their
characteristics and that of the target firm. We have shown that this weighting scheme
results in greater accuracy than others that have been proposed.
The only characteristics that are important in the weighting scheme are industry and
predicted growth rate. All comparable firms from the same industry should be weighted
by the inverse of the difference between their long term growth rate and that of the target
firm. Once this is done, matching other characteristics such as size, dividend payout,
accounting measures of rate of return, leverage, Fama-French factors, and analyst
disagreement plays almost no role in improving a valuation using multiples. Further
significant improvement results from correcting earnings forecasts for known biases.
Using the weighting scheme and correcting earnings forecasts improves the variance of
valuation errors by about half. A final improvement for firms with a prior history of
traded share price can be achieved by allowing for persistence in valuation errors. In
combination these three improvements reduce the variance of the valuation error by
more than 60%. The remaining error appears to consist of random noise in relative
equity values plus a governance factor that is important for a limited number of firms.
Our study has also confirmed two puzzles about equity valuation using multiples.
Theoretically, it should be better to match more characteristics of the target firm than
just its growth rate. However, sophisticated matching schemes using other
characteristics do not appear to improve the accuracy of valuations. We have also
confirmed the related puzzle that methods which are theoretically superior to P/E ratios
(such as EV/EBITDA and residual income-based value-drivers) have been shown by
22
LNT to be outperformed by the P/E ratio. Both these puzzles suggest that equity values
are determined in a relatively simple way that conflicts with the richness of standard
theoretical models of equity valuation. However, at a deeper level that should not be the
case because irrationally simplistic valuations should lead to arbitrage opportunities.
Hopefully, our characterization of multiples-based valuation as a replication of the
characteristics of the target firm is a step in the direction of understanding these two
puzzles.
23
Appendix 1: Derivation of the model
Let X 0i be the value-driver that is used as the basis of the multiple. T is the target firm to
be valued. Let Ci be a linear index of other characteristics for firm i. Assume that this
index combines linearly in a portfolio, which will be the case if all the variables included
in the index combine linearly in a portfolio. Use N comparable firms. The condition that
the portfolio of comparables replicates the value-driver of the target firm is:
N
X 0T  Wi X 0i / Pi (A1.1)
i 1
The condition that the portfolio of comparables replicates the weighted characteristic
measure of the target firm is:
N
CT  Wi Ci / Pi (A1.2)
i 1
The estimated value of the target firm is the value of the replicating portfolio:
N
PˆT  Wi (A1.3)
i 1
N
Define wi  Wi / Wi , and mi  X 0i / Pi . Divide (A1.1) by (A1.3) to give:
i 1
X 0T / PˆT  i 1 wi mi
N
(A1.4)
(A1.4) is the valuation equation whereby the estimated multiple of the target firm is
expressed as a weighted harmonic average of the multiples of comparable firms. To
derive the weighting scheme, divide (A1.2) by (A1.3) to give:
CT / PˆT  i 1 wiCi / Pi
N
(A1.5)
Define ci  (Ci / Pi ) is the scaled index of characteristics of firm i. Rearrange (A1.5) to

give:

N
i 1
wi (ci  cT )  0 (A1.6)
One simple solution to (A1.6) is to pick an equal number of comparables with

characteristic index, Ci , above and below the target firm’s index, CT , and set
wi  1/ ABS (di ) where di  (ci  cT ) .
24
Appendix 2: Rate of return decomposition
For a particular firm, let Mˆ t be the fitted multiple at date t, and M t the actual multiple.
Define the log valuation error at time t as:
LVEt  ln( Pt / Pˆt )  ln(M t / Mˆ t ) (A2.1)
Let Rt 1,t be the rate of return between t-1 and t. By definition:
Rt 1,t  ( Pt  Dt ) / Pt 1 (A2.2)
Where Dt is the dividend paid in the period. The return is then equal to:
Rt 1,t  ( Pt / Pt 1 )*[( Pt  Dt ) / Pt ] (A2.3)
Using the fact that Pt  M t Et :
Rt 1,t  (M t Et / M t 1Et 1 )*[( Pt  Dt ) / Pt ] (A2.4)
Taking logs of (A2.4) and using:

ln(M t )  LVEt  ln(Mˆ t ) (A2.5)
The log return can be decomposed as:
ln( Rt 1,t )  LVEt 1,t  ln(Mˆ t / Mˆ t 1 )  ln( Et / Et 1 )  ln[( Pt  Dt ) / Pt ] (A2.6)
Where:
LVEt 1,t  LVEt  LVEt 1 (A2.7)
25
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Figure 1: Proportions of industries with different optimal multiples, by year
The figure shows the proportion of 72 IBES industries for which each multiple gives the
lowest standard deviation of the valuation error, by year. PE is price to 1-year forward
earnings, PB is price to book, EVS is enterprise value to sales.
28
Table 1: Distribution of Variables
Summary descriptions of the variables are as follows (all amounts are on per share basis): P is stock price; EPS1 is one year out EPS forecast;
indpeps1 is the industry harmonic mean of P/EPS1; indpm is the industry profit margin defined as operating profit divided buy sales; adjpm is
the difference between the firm’s profit margin and the industry profit margin; losspm is adjpm*indicator variable, where the indicator variable
is 1 if profit margin is negative and 0 otherwise; adjgro is the difference between the analysts’ consensus forecast of the firm’s long-term growth
and the industry average; lev is total long-term debt scaled by the book value of stockholders’ equity; rnoa is operating profit scaled by net
operating assets; roe is return on equity; rd is the firm’s R&D expense scaled by sales; MVE is the market value of equity; DISGS is the
disagreement among analyst forecasts; DIVIDS is the dividend payout ratio. Sample firms are collected in April each year between 1982 and
2010, and we require non-missing values for a set of core financial variables from COMPUSTAT, and non-missing share price, 1 and 2-year out
EPS forecasts and long-term growth forecasts from IBES. The sample in Panel A is trimmed at 1% and 99% for the P/EPS1 ratio using the
pooled distribution, resulting in a sample of 39,872 firm-years. Panel B (LNT sample restriction) also requires 30 non-missing monthly returns
from the prior 60 months from CRSP, and the sample is trimmed at 1% and 99% for 14 value driver ratios using the pooled distribution,
resulting in a sample of 30,111 firm-years. Panel C (BL sample restriction) requires the variables included in the warranted multiple calculation
to be available, and trims them at 1% and 99% of the pooled distribution resulting in a sample of 35,690 firm-years.
Panel A: Our sample
Mean Median Sd 1% 10% 25% 50% 75% 90% 99%
P/EPS1 17.5170 14.7604 11.3259 5.4845 8.6581 11.1159 14.7604 20.1051 28.5714 61.7458
indpeps1 1.2797 1.1215 0.6885 0.3800 0.6691 0.8841 1.1215 1.5002 1.9957 4.1000
indpm 0.0251 0.0036 0.1414 -0.2235 -0.0851 -0.0408 0.0036 0.0771 0.1768 0.3961
losspm -0.0292 0.0000 0.0917 -0.2235 -0.0851 -0.0408 0.0000 0.0000 0.0000 0.0000
adjgro 0.1907 0.0000 1.3517 -2.2436 -0.6088 -0.2723 0.0000 0.4153 1.1644 4.2925
lev 2.0012 0.3901 255.6765 0.0000 0.0000 0.0762 0.3901 0.8757 1.5166 5.8045
rnoa 27.1761 18.6628 325.6710 -20.2711 6.9114 11.4283 18.6628 30.8241 49.7218 203.1888
roe 0.2036 0.1275 14.7395 -0.4166 0.0301 0.0804 0.1275 0.1757 0.2489 0.7411
rd 0.0239 0.0000 0.0614 0.0000 0.0000 0.0000 0.0000 0.0158 0.0846 0.2618
MVE 4074.8 758.3 15490.1 26.8 106.7 258.1 758.3 2444.0 7577.8 61489.9
DISGS 0.0498 0.0300 0.0436 0.0100 0.0100 0.0200 0.0300 0.0700 0.1100 0.1900
DIVIDS 0.6148 0.2055 3.7230 0.0000 0.0000 0.0000 0.2055 0.6206 1.3158 5.3381
Firm-years 39,872
Panel B: With LNT restrictions
Mean Median Sd 1% 10% 25% 50% 75% 90% 99%
P/EPS1 17.7094 15.4615 10.3326 6.2195 9.4528 11.9142 15.4615 20.2627 27.5811 56.5779
indpeps1 1.2889 1.1412 0.6354 0.4876 0.7057 0.8970 1.1412 1.5106 1.9587 4.0974
indpm 0.0024 -0.0050 0.0794 -0.1664 -0.0839 -0.0462 -0.0050 0.0392 0.1114 0.2297
losspm -0.0279 -0.0050 0.0411 -0.1664 -0.0839 -0.0462 -0.0050 0.0000 0.0000 0.0000
adjgro 0.1130 0.0000 0.5913 -0.8184 -0.4453 -0.2121 0.0000 0.2764 0.7619 2.3992
lev 0.5802 0.4369 0.6763 0.0000 0.0000 0.1234 0.4369 0.8367 1.2659 3.1026
rnoa 25.4971 19.0770 25.6457 0.5075 8.0004 12.0351 19.0770 30.9624 48.0282 128.7189
roe 0.1378 0.1298 0.1240 -0.1770 0.0348 0.0829 0.1298 0.1818 0.2530 0.5350
rd 0.0253 0.0000 0.0488 0.0000 0.0000 0.0000 0.0000 0.0265 0.0891 0.2197
MVE 5293.5 1139.1 17397.7 44.7 173.1 422.2 1139.1 3448.8 10565.2 76375.4
DISGS 0.0588 0.0500 0.0467 0.0100 0.0100 0.0200 0.0500 0.0800 0.1300 0.2100
DIVIDS 0.6537 0.2386 2.7434 0.0000 0.0000 0.0000 0.2386 0.6857 1.4254 5.6721
Firm-years 30,111
Panel C: With BL restrictions

Mean Median Sd 1% 10% 25% 50% 75% 90% 99%
P/EPS1 17.979 15.569 11.043 6.108 9.392 11.892 15.569 20.593 28.240 58.953
indpeps1 1.290 1.141 0.641 0.480 0.706 0.899 1.141 1.509 1.983 3.968
indpm 0.003 -0.005 0.081 -0.170 -0.084 -0.046 -0.005 0.040 0.113 0.233
losspm -0.028 -0.005 0.042 -0.170 -0.084 -0.046 -0.005 0.000 0.000 0.000
adjgro 0.164 0.000 0.658 -0.805 -0.431 -0.199 0.000 0.345 0.905 2.783
lev 0.586 0.429 0.736 0.000 0.000 0.107 0.429 0.840 1.299 3.404
rnoa 25.976 19.431 26.544 0.513 8.063 12.219 19.431 31.411 48.613 131.052
roe 0.139 0.130 0.129 -0.194 0.034 0.082 0.130 0.184 0.258 0.553
rd 0.025 0.000 0.048 0.000 0.000 0.000 0.000 0.025 0.087 0.216
MVE 4874.9 1020.2 16530.3 41.0 159.4 382.2 1020.2 3104.8 9536.2 73061.8
DISGS 0.056 0.040 0.046 0.010 0.010 0.020 0.040 0.080 0.120 0.200
DIVIDS 0.626 0.193 3.135 0.000 0.000 0.000 0.193 0.635 1.363 5.634
Firm-years 35,690
30
Table 2: Accuracy of different weighting schemes
The table shows measures of the accuracy of valuation for various implementations
using the prospective earnings multiple. Estimated values use the harmonic mean of
P/EPS1 multiples of comparable companies. In all cases comparables are chosen from
the same IBES industry. Comparable companies are either all in the same industry as the
target (“All”) or the 4 closest chosen by the selection criterion indicated (“4”). The
measure used as the selection criterion is indicated in each panel. The means of the
comparable firms are either weighted (“Yes”) or unweighted (“No”). When weights are
used they are proportional to inverse distance. Distance is the difference between the
indicated measure for the target and comparable firm. We define the valuation error for
firm i at time t by: VEit  ( Pit / Pît )  1 where Pit is the price of share i at time t, and Pît is
the estimated price of share i at time t. The most accurate method in any sub-panel by a
given accuracy measure is in bold. The most accurate method in the whole panel is
underlined.
Panel A: Our sample
Weighted
25%- 10%-
Number of comparables Selection by
Mean Median STD 75% 90%
in industry criterion inverse
range range
distance
Panel A: LNT and BL procedures
(LNT) All None 0.55% -2.39% 36.76% 39.85% 85.34%
(BL) 4 BLW None 4.62% -1.11% 42.71% 42.20% 91.83%
Panel B: Distance measure is raw earnings growth (g)
All g Yes -0.29% -3.29% 35.76% 37.59% 81.35%
All None 0.55% -2.39% 36.76% 39.85% 85.34%
4 g Yes 3.62% -1.84% 41.92% 40.45% 88.71%
4 g None 3.26% -1.96% 41.19% 40.26% 88.07%
Panel C: Distance measure is industry-corrected earnings growth (adjgro)
All adjgro Yes 0.73% -2.89% 36.85% 36.89% 81.97%
All None 0.55% -2.39% 36.76% 39.85% 85.34%
4 adjgro Yes 4.14% -1.93% 43.89% 42.07% 92.80%
4 adjgro None 3.34% -1.98% 41.32% 40.71% 89.29%
Panel D: Distance measure is BL warranted multiple (BLW)
All BLW Yes 0.76% -3.56% 38.35% 41.45% 86.69%
All None 0.55% -2.42% 36.93% 40.07% 85.81%
4 BLW Yes 4.28% -2.55% 45.34% 44.71% 98.14%
4 BLW None 4.62% -1.11% 42.71% 42.20% 91.83%
Panel B: Bhojraj and Lee (BL) sample restrictions
Weighted
25%- 10%-
Number of comparables in Selection by
industry criterion inverse
range range
distance
(LNT) All None 0.66% -2.46% 35.67% 39.38% 83.19%
(BL) 4 BLW None 1.91% -2.78% 38.80% 38.93% 83.27%
All g Yes -0.11% -3.11% 34.74% 36.87% 79.09%
All None 0.66% -2.46% 35.67% 39.38% 83.19%
4 g Yes 2.68% -2.33% 39.09% 39.13% 85.08%
4 g None 2.29% -2.34% 38.41% 39.05% 84.76%
All adjgro Yes 0.75% -2.87% 36.71% 37.63% 82.03%
All None 0.66% -2.46% 35.67% 39.38% 83.19%
4 adjgro Yes 3.55% -2.01% 41.75% 40.35% 88.39%
4 adjgro None 2.26% -2.49% 38.98% 39.04% 85.25%
All BLW Yes 0.58% -3.02% 37.02% 37.83% 82.03%
All None 0.66% -2.46% 35.80% 39.57% 83.61%
4 BLW Yes 3.38% -2.14% 42.34% 40.29% 87.90%
4 BLW None 1.91% -2.78% 38.80% 38.93% 83.27%
32
Panel C: Liu, Nissim, Thomas (LNT) sample restrictions
Weighted
25%- 10%-
Number of comparables in Selection by
industry criterion inverse
range range
distance
(LNT) All None 0.65% -2.28% 34.31% 37.72% 79.87%
(BL) 4 BLW None 1.77% -2.31% 38.07% 37.10% 79.68%
All g Yes 0.00% -2.63% 33.68% 35.38% 76.38%
All None 0.65% -2.28% 34.31% 37.72% 79.87%
4 g Yes 2.46% -2.17% 37.83% 37.40% 82.24%
4 g None 2.10% -2.31% 37.27% 37.24% 81.86%
All adjgro Yes 0.73% -2.47% 35.37% 36.17% 78.97%
All None 0.65% -2.28% 34.31% 37.72% 79.87%
4 adjgro Yes 3.26% -1.72% 40.10% 38.67% 85.39%
4 adjgro None 2.04% -2.34% 37.87% 37.37% 82.26%
All BLW Yes 0.82% -2.61% 36.25% 36.31% 79.28%
All None 0.66% -2.28% 34.44% 37.92% 80.23%
4 BLW Yes 3.42% -1.86% 41.76% 38.60% 85.03%
4 BLW None 1.77% -2.31% 38.07% 37.10% 79.68%
33
Table 3: Valuation errors and mismatching of characteristics
The table shows regressions, year-by-year and for the pooled sample, of the valuation
error of target firm T on the differences between its characteristics and the portfolio of
comparable firms used in its valuation:
VET = a +  b j CT , j + eT
j
Where VET is the valuation error for target firm T, defined as VET  ( PT / PˆT )  1 , where
P is the price of share T, and Pˆ is the estimated price of share T. ΔCT,j is the difference
T T
in characteristics between the target firm and the portfolio represented by the multiple
valuation, defined as:
ΔCT,j = CT,j -  wT ,i Ci , j
i
Where CT,j is the value of characteristic j for firm T, wT,i is the weight given to
comparable firm i in the estimated multiple for firm T, and Ci , j is the value of
characteristic j for firm i. The characteristics are (b) the long-run g (the growth rate and
the growth rate, (c) size measured by market value of equity, (d) payout ratio, (e)
dispersion of analysts’ forecasts (“disagree”), and (f) beta. The adjusted R2 is also
reported. The pooled sample results (“ALL”) report Newey-West autocorrelation-
corrected t-statistics. Panel A uses the unweighted harmonic mean of all firms in the
industry as comparables. Panel B uses all firms in the industry weighted by the inverse
of the difference between the growth rates of the target and comparable firms.
Panel A: Unweighted harmonic mean
Adjusted
Const b c d e f R-square
1983 0.005 -1.689 0.004 -0.008 0.330 0.000 9.79%

( 0.51) (-7.32)*** ( 0.57) (-1.41) ( 1.32) (-0.)
1984 0.002 -2.111 0.002 -0.003 -0.148 0.050 10.22%
( 0.23) (-8.41)*** ( 0.31) (-0.46) (-0.63) ( 1.99)**
1985 0.007 -1.447 0.003 0.002 -0.249 -0.023 8.70%
( 0.76) (-7.49)*** ( 0.53) ( 0.61) (-1.36) (-1.21)
1986 0.000 -1.766 0.008 -0.001 -0.355 0.076 7.36%
( 0.) (-7.33)*** ( 1.35) (-0.23) (-1.88)* ( 3.38)***
1987 -0.009 -1.984 -0.003 -0.026 -0.409 0.102 9.04%
(-0.84) (-7.42)*** (-0.44) (-4.)*** (-1.69)* ( 3.35)***
1988 -0.003 -1.793 -0.001 -0.002 -0.055 0.103 7.17%
(-0.29) (-7.5)*** (-0.1) (-1.25) (-0.27) ( 2.69)***
1989 -0.003 -2.313 -0.003 -0.001 -0.594 0.089 10.05%
(-0.3) (-9.35)*** (-0.46) (-1.31) (-2.65)*** ( 2.3)**
1990 -0.001 -1.821 0.000 -0.011 -0.891 0.021 10.14%
(-0.07) (-8.42)*** (-0.02) (-2.18)** (-4.46)*** ( 0.66)
1991 0.007 -2.037 0.001 -0.006 -0.962 0.051 14.01%
( 0.72) (-11.17)*** ( 0.09) (-2.15)** (-5.07)*** ( 2.67)***
1992 -0.003 -1.700 -0.006 -0.012 -0.783 0.022 9.33%
(-0.33) (-9.19)*** (-1.04) (-2.58)*** (-4.11)*** ( 1.22)
34
1993 -0.008 -1.578 0.005 -0.005 -0.718 0.036 7.89%
(-0.98) (-9.49)*** ( 1.08) (-1.11) (-3.79)*** ( 2.57)***
1994 -0.013 -2.001 -0.013 -0.009 -0.368 0.016 12.01%
(-1.6) (-12.73)*** (-2.57)*** (-1.86)* (-1.94)* ( 1.4)
1995 0.003 -1.747 -0.001 0.002 -1.134 0.011 12.39%
( 0.31) (-13.04)*** (-0.29) ( 0.33) (-6.)*** ( 1.)
1996 -0.007 -1.577 0.003 -0.022 -1.275 0.008 13.51%
(-0.94) (-13.16)*** ( 0.76) (-5.18)*** (-7.89)*** ( 0.91)
1997 -0.003 -1.548 -0.006 -0.008 -1.474 0.001 12.70%
(-0.33) (-11.58)*** (-1.29) (-5.57)*** (-8.64)*** ( 0.05)
1998 -0.001 -1.450 -0.008 -0.021 -2.838 0.009 11.25%
(-0.11) (-7.74)*** (-1.21) (-3.94)*** (-11.74)*** ( 0.44)
1999 0.007 -2.802 -0.007 -0.010 -1.980 0.016 14.04%
( 0.56) (-13.02)*** (-0.96) (-2.72)*** (-7.32)*** ( 0.61)
2000 0.011 -1.341 -0.004 -0.004 -3.022 -0.015 12.49%
( 0.8) (-8.28)*** (-0.5) (-1.9)* (-9.53)*** (-0.6)
2001 0.009 -1.421 -0.008 -0.031 -1.281 -0.039 8.80%
( 0.87) (-7.8)*** (-1.22) (-2.36)** (-5.44)*** (-2.04)**
2002 0.002 -1.505 -0.007 -0.054 -1.393 -0.046 8.44%
( 0.25) (-7.74)*** (-1.22) (-4.05)*** (-6.18)*** (-3.13)***
2003 0.001 -1.481 -0.001 -0.039 -0.452 -0.044 11.88%
( 0.17) (-11.49)*** (-0.16) (-4.53)*** (-2.3)** (-3.84)***
2004 -0.001 -1.321 0.000 -0.038 -0.945 -0.024 9.01%
(-0.07) (-11.21)*** (-0.08) (-2.62)*** (-4.18)*** (-2.11)**
2005 0.002 -1.957 0.005 -0.025 -0.384 0.004 15.62%
( 0.25) (-15.84)*** ( 0.87) (-3.74)*** (-1.44) ( 0.31)
2006 0.004 -1.561 0.007 -0.011 -0.560 0.015 10.23%
( 0.52) (-12.76)*** ( 1.52) (-2.68)*** (-2.02)** ( 1.64)
2007 -0.005 -1.165 0.019 -0.007 -1.194 0.013 7.47%
(-0.53) (-9.21)*** ( 3.36)*** (-1.75)* (-2.63)*** ( 1.22)
2008 -0.006 -1.690 -0.019 -0.149 -2.986 0.024 9.57%
(-0.42) (-6.88)*** (-2.12)** (-7.92)*** (-4.36)*** ( 1.12)
2009 -0.002 -1.255 0.009 -0.044 -0.862 0.066 8.39%
(-0.15) (-8.83)*** ( 1.34) (-4.58)*** (-1.64) ( 3.54)***
2010 0.001 -1.397 0.007 -0.040 -1.398 0.144 11.09%
( 0.12) (-9.23)*** ( 1.03) (-2.88)*** (-2.69)*** ( 8.44)***
ALL 0.000 -1.695 0.000 -0.021 -1.014 0.025 10.45%
(-0.07) (-5.16)*** (-0.29) (-2.88)*** (-3.6)*** ( 2.17)**
35
Panel B: Weighted harmonic mean
Adjusted
Const b c d e f R-square
1983 0.002 -1.110 0.000 -0.008 0.250 0.013 3.95%

( 0.16) (-4.79)*** ( 0.04) (-1.37) ( 0.99) ( 0.43)
1984 -0.002 -1.497 0.001 -0.003 -0.205 0.052 5.06%
(-0.25) (-6.03)*** ( 0.14) (-0.41) (-0.89) ( 2.06)**
1985 -0.001 -0.939 0.003 0.001 -0.237 -0.032 4.18%
(-0.09) (-4.91)*** ( 0.58) ( 0.48) (-1.31) (-1.68)*
1986 -0.006 -1.231 0.007 -0.001 -0.332 0.072 3.63%
(-0.58) (-5.02)*** ( 1.03) (-0.29) (-1.73)* ( 3.15)***
1987 -0.013 -1.478 -0.004 -0.027 -0.462 0.101 6.22%
(-1.18) (-5.39)*** (-0.54) (-4.03)*** (-1.87)* ( 3.26)***
1988 -0.010 -1.256 -0.001 -0.003 -0.158 0.110 3.56%
(-0.93) (-5.22)*** (-0.2) (-1.36) (-0.76) ( 2.85)***
1989 -0.009 -1.576 -0.005 -0.001 -0.581 0.103 5.06%
(-0.88) (-6.4)*** (-0.81) (-01.) (-2.61)*** ( 2.66)***
1990 -0.004 -1.176 -0.002 -0.012 -0.826 0.025 5.43%
(-0.36) (-5.31)*** (-0.27) (-2.48)** (-4.04)*** ( 0.78)
1991 -0.001 -1.312 -0.003 -0.006 -0.919 0.053 8.00%
(-0.16) (-7.48)*** (-0.47) (-2.25)** (-5.03)*** ( 2.89)***
1992 -0.003 -1.000 -0.005 -0.012 -0.803 0.023 4.48%
(-0.38) (-5.39)*** (-0.87) (-2.6)*** (-4.2)*** ( 1.27)
1993 -0.017 -1.080 0.004 -0.006 -0.752 0.037 4.34%
(-2.03)** (-6.57)*** ( 0.85) (-1.37) (-4.02)*** ( 2.7)***
1994 -0.020 -1.386 -0.014 -0.009 -0.354 0.012 6.31%
(-2.44)** (-8.84)*** (-2.71)*** (-1.81)* (-1.87)* ( 1.03)
1995 -0.011 -1.084 -0.002 0.001 -1.173 0.017 6.58%
(-1.35) (-8.29)*** (-0.5) ( 0.13) (-6.35)*** ( 1.59)
1996 -0.016 -0.975 0.004 -0.021 -1.227 0.006 8.36%
(-2.24)** (-8.37)*** ( 0.85) (-5.08)*** (-7.81)*** ( 0.62)
1997 -0.010 -0.874 -0.006 -0.008 -1.388 -0.001 7.92%
(-1.33) (-6.66)*** (-1.26) (-5.27)*** (-8.3)*** (-0.08)
1998 0.000 -0.991 -0.008 -0.020 -2.845 0.006 9.64%
(-0.02) (-5.22)*** (-1.3) (-3.7)*** (-11.61)*** ( 0.29)
1999 -0.011 -1.652 -0.006 -0.010 -1.883 0.023 7.05%
(-0.87) (-7.67)*** (-0.9) (-2.7)*** (-6.96)*** ( 0.84)
2000 -0.003 -0.708 -0.005 -0.004 -2.886 0.000 8.32%
(-0.19) (-4.41)*** (-0.67) (-1.67)* (-9.18)*** ( 0.02)
2001 0.002 -0.832 -0.007 -0.035 -1.301 -0.037 5.31%
( 0.16) (-4.58)*** (-1.04) (-2.67)*** (-5.55)*** (-1.95)*
2002 0.001 -0.975 -0.008 -0.056 -1.356 -0.040 5.80%
( 0.09) (-5.01)*** (-1.32) (-4.17)*** (-6.01)*** (-2.77)***
36
2003 -0.009 -0.975 -0.003 -0.039 -0.438 -0.039 6.77%
(-1.23) (-7.7)*** (-0.71) (-4.67)*** (-2.27)** (-3.5)***
2004 -0.013 -0.800 0.000 -0.036 -0.953 -0.023 4.29%
(-1.72)* (-6.85)*** (-0.1) (-2.49)** (-4.25)*** (-2.05)**
2005 -0.014 -1.179 0.003 -0.024 -0.445 0.008 6.57%
(-1.61) (-9.6)*** ( 0.58) (-3.54)*** (-1.68)* ( 0.68)
2006 -0.008 -1.006 0.008 -0.010 -0.540 0.023 5.05%
(-1.09) (-8.39)*** ( 1.69)* (-2.59)*** (-1.99)** ( 2.61)***
2007 -0.016 -0.765 0.017 -0.008 -1.128 0.016 4.10%
(-1.61) (-6.12)*** ( 3.)*** (-2.03)** (-2.52)** ( 1.47)
2008 -0.003 -1.248 -0.022 -0.148 -2.732 0.022 7.91%
(-0.22) (-5.04)*** (-2.44)** (-7.79)*** (-3.96)*** ( 1.02)
2009 -0.011 -0.881 0.008 -0.042 -0.709 0.068 5.47%
(-0.99) (-6.25)*** ( 1.24) (-4.42)*** (-1.36) ( 3.63)***
2010 -0.009 -0.911 0.005 -0.035 -1.578 0.145 8.84%
(-0.83) (-6.14)*** ( 0.79) (-2.61)*** (-3.1)*** ( 8.69)***
ALL -0.008 -1.103 -0.001 -0.021 -0.999 0.027 6.01%
(-3.78)*** (-5.03)*** (-1.03) (-2.89)*** (-3.68)*** ( 2.34)**
37
Table 4: Valuation errors using differences in characteristics to adjust valuations
The table shows the improvement in valuation accuracy from using the difference in
characteristics between the target and comparable firms to adjust the estimated multiple.
The adjusted valuation error is given by:
VET ,t  VET ,t  at 1   b j ,t 1CT , j ,t
j
Where VET ,t is the valuation error for target firm T at time t, at 1 and b j ,t 1 are the
coefficients of regression (9) estimated at time (t-1), CT , j ,t are the differences in
characteristics for target firm T measured at time t.
PANEL A (unadjusted)
mean median STD 25%-75% 10%-90%
(unweighted ) all in industry 0.55% -2.39% 36.76% 39.85% 85.34%
(weighted) all in industry -0.29% -3.29% 35.76% 37.59% 81.35%
PANEL B (adjusted by differences in characteristics)

(unweighted ) all in industry -0.05% -3.05% 34.46% 35.93% 77.35%
38
Table 5: Persistence of valuation errors
The table shows the result of the regression:
VEi,t = a + b*VEi,t-1 + ei,t
Where VEi,t is the valuation error for firm i at time t. The adjusted R2 is also reported.
The pooled sample results (“ALL”) report Newey-West autocorrelation-corrected t-
statistics. The left-hand panel uses the unweighted harmonic mean of all firms in the
industry as comparables. The right-hand panel uses all firms in the industry weighted by
the inverse of the difference between the growth rates of the target and comparable firms.
Unweighted harmonic Mean (all in

industry) Weighted harmonic Mean (all in industry)
const b Adjusted const b Adjusted

R-square R-square
1983 0.018 0.624 37.95% 1983 0.014 0.608 32.83%

( 1.68)* ( 15.36)*** ( 1.32) ( 13.74)***
1984 0.006 0.628 44.56% 1984 0.001 0.567 37.63%
( 0.69) ( 20.03)*** ( 0.11) ( 17.36)***
1985 -0.008 0.640 47.99% 1985 -0.010 0.581 39.72%
(-1.1) ( 22.26)*** (-1.47) ( 18.82)***
1986 -0.002 0.757 46.63% 1986 -0.007 0.702 40.09%
(-0.25) ( 21.9)*** (-0.89) ( 19.17)***
1987 0.005 0.743 48.90% 1987 0.005 0.732 46.18%
( 0.63) ( 23.17)*** ( 0.52) ( 21.94)***
1988 0.004 0.711 51.70% 1988 0.002 0.685 48.41%
( 0.56) ( 25.09)*** ( 0.3) ( 23.49)***
1989 0.011 0.775 50.05% 1989 0.007 0.716 45.42%
( 1.35) ( 25.5)*** ( 0.89) ( 23.24)***
1990 0.004 0.574 35.84% 1990 -0.002 0.541 30.77%
( 0.49) ( 19.69)*** (-0.18) ( 17.56)***
1991 0.016 0.657 42.89% 1991 0.007 0.604 39.30%
( 2.09)** ( 23.6)*** ( 0.92) ( 21.91)***
1992 0.001 0.614 42.54% 1992 0.002 0.604 37.04%
( 0.21) ( 24.33)*** ( 0.25) ( 21.69)***
1993 -0.003 0.587 35.33% 1993 -0.014 0.528 29.85%
(-0.37) ( 22.51)*** (-2.06)** ( 19.88)***
1994 0.009 0.617 32.13% 1994 0.004 0.550 25.38%
( 1.26) ( 23.3)*** ( 0.49) ( 19.76)***
1995 0.009 0.690 43.59% 1995 -0.008 0.591 36.46%
( 1.31) ( 31.08)*** (-1.2) ( 26.79)***
1996 0.010 0.523 32.58% 1996 0.001 0.462 26.09%
( 1.58) ( 25.95)*** ( 0.22) ( 22.19)***
1997 0.003 0.633 35.38% 1997 -0.006 0.588 28.91%
( 0.41) ( 28.95)*** (-0.9) ( 24.96)***
1998 0.014 0.757 26.77% 1998 0.019 0.788 25.26%
( 1.34) ( 23.35)*** ( 1.89)* ( 22.46)***
39
1999 0.053 0.644 29.32% 1999 0.023 0.574 24.92%
( 4.49)*** ( 23.03)*** ( 1.94)* ( 20.6)***
2000 0.010 0.604 33.05% 2000 0.009 0.564 27.07%
( 0.87) ( 23.22)*** ( 0.77) ( 20.14)***
2001 0.009 0.400 22.34% 2001 0.001 0.368 18.21%
( 0.93) ( 16.65)*** ( 0.09) ( 14.66)***
2002 0.002 0.648 36.97% 2002 0.006 0.639 34.75%
( 0.24) ( 24.79)*** ( 0.69) ( 23.62)***
2003 0.028 0.493 36.48% 2003 0.013 0.443 31.22%
( 3.97)*** ( 25.95)*** ( 1.89)* ( 23.08)***
2004 0.006 0.673 47.24% 2004 -0.004 0.637 41.22%
( 0.98) ( 33.96)*** (-0.67) ( 30.06)***
2005 0.020 0.750 48.36% 2005 0.011 0.686 42.21%
( 3.11)*** ( 35.63)*** ( 1.72)* ( 31.47)***
2006 0.015 0.638 50.74% 2006 0.010 0.610 45.36%
( 2.56)*** ( 38.3)*** ( 1.7)* ( 34.39)***
2007 0.018 0.819 43.79% 2007 0.013 0.790 38.88%
( 2.37)** ( 32.45)*** ( 1.71)* ( 29.32)***
2008 0.012 0.718 26.65% 2008 0.021 0.704 24.58%
( 0.88) ( 19.7)*** ( 1.58) ( 18.66)***
2009 0.008 0.478 37.21% 2009 -0.006 0.434 33.25%
( 0.85) ( 23.79)*** (-0.66) ( 21.81)***
2010 -0.009 0.763 51.54% 2010 -0.016 0.705 45.67%
(-1.05) ( 33.28)*** (-1.83)* ( 29.59)***
ALL 0.010 0.648 39.95% ALL 0.003 0.607 34.88%
( 3.25)*** ( 5.15)*** ( 1.6) ( 5.11)***
40
Table 6: Valuation errors when lagged valuation errors are used to adjust
valuations
The table shows the improvement in valuation accuracy from using the lagged valuation
error to adjust the estimated price. We adjust the estimated price at time t by the
predicted valuation error determined by the valuation error at time (t-1) combined with
the coefficient from regressing the valuation error at time (t-1) on the valuation error at
time (t-2).
PANEL A (unadjusted)
PANEL B (adjusted by lagged valuation error)

(weighted) all in industry 0.30% -1.39% 27.64% 25.36% 56.91%
41
Table 7: Valuation errors when earnings forecasts are corrected for known biases
and lagged valuation errors are used to adjust valuations
The table shows the improvement in valuation accuracy from using the procedure in
Mohanram and Gode (2013) to correct known biases in earnings forecasts before
valuing equities using multiples. The effect of also using the lagged valuation error to
adjust the estimated price is also shown. Earnings surprises in a year, defined as the
difference between expected and actual EPS, are regressed on the lagged values of total
accruals, sales growth, analysts’ long-term growth estimate, change in PPE, change in
other long-term assets, 12-month share return, and the revision in the earnings forecast.
Coefficients from the prior year’s regression are used to forecast the earnings surprise in
a given year, and this is added to the earnings forecast. The revised earnings forecasts
are then used to implement the valuation using multiples. Unweighted uses all firms in
the industry with equal weights. Weighted uses all firm in the industry with weights
inversely proportional to the difference between their expected growth rate and that of
the target firm. Panel A does not include an adjustment for the lagged valuation error,
and Panel B does include this adjustment.
Panel A: No lag error adjustment

Unadjusted earnings
unweighted 0.0075 -0.0142 0.3189 0.3343 0.7298
weighted 0.0012 -0.0218 0.3108 0.3168 0.6902
Earnings forecast adjusted using Mohanram-Gode approach
unweighted 0.0016 -0.0134 0.2783 0.2960 0.6455
weighted -0.0082 -0.0158 0.2310 0.2469 0.5300
Panel B: Lag error adjustment

Unadjusted earnings
unweighted 0.0062 -0.0101 0.2458 0.2262 0.5079
weighted 0.0021 -0.0114 0.2449 0.2206 0.5088
Earnings forecast adjusted using Mohanram-Gode approach
unweighted -0.0011 -0.0108 0.2226 0.2048 0.4726
weighted -0.0062 -0.0122 0.1963 0.1812 0.4048
42
Table 8: Transition matrix between optimal multiples by industry
The table shows the transition matrix from one year to the next in the multiple (PE, PB,
EVS) that gives the smallest standard deviation of the valuation error for each IBES
industry.
Optimal in year (t+1)
Optimal in year t: PE PB EVS
PE 0.899 0.077 0.024
PB 0.603 0.379 0.017
EVS 0.771 0.029 0.300
43
Table 9: Dependence of components of the rate of return on the lagged valuation
error
The table shows the results of regressing components of the rate of return on the lagged
valuation error:
Dependent variable = a + b*VEt-1 + error
Rt ,t 1 is the rate of return between t and (t+1), LVEt 1,t is the change in the log valuation
error defined as LVE  LVE  LVE , LVE  ln(M / Mˆ ) , Mˆ is the fitted multiple
t 1,t t t 1 t t t t
at date t, M t the actual multiple at time t, Et is the one-year earnings forecast at time t,
Pt is the price at time t, and Dt is the dividend paid between (t-1) and t.
LogMhat  ln( Mˆ t / Mˆ t 1 ) , LogE  ln( Et / Et 1 ) , Divyield  ln[( Pt  Dt ) / Pt ] .
Dependent variable Const b Adjusted

r-square
Panel A: Unweighted harmonic mean multiples
ΔLVE 0.014 -0.390 21.43%
( 3.85)*** (-4.99)***
ΔLogMhat 0.053 0.290 8.84%
( 1.67)* ( 4.38)***
ΔLogE 0.043 0.184 3.61%
( 2.22)** ( 4.26)***
Divyield 0.047 -0.018 1.66%
( 3.59)*** (-2.14)**
Return 0.114 -0.105 2.43%
( 3.12)*** (-3.15)***
Panel B: Weighted harmonic mean multiples
ΔLVE 0.018 -0.438 23.70%
( 4.08)*** (-4.94)***
ΔLogMhat 0.050 0.326 8.17%
( 1.57) ( 4.43)***
ΔLogE 0.042 0.220 3.48%
( 2.18)** ( 4.1)***
Divyield 0.047 -0.017 1.19%
( 3.58)*** (-1.74)*
Return 0.115 -0.113 1.98%
( 3.12)*** (-2.96)***
44

Is There A Limit To The Accuracy of Equity Valuation Using Multiples?

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Is There A Limit To The Accuracy of Equity Valuation Using Multiples?

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Is there a limit to the accuracy of equity valuation

JEL Codes: G11, G24, D81.

Electronic copy available at: http://ssrn.com/abstract=2291869

Although the use of multiples is widespread in financial analysis books (Damodaran

Electronic copy available at: http://ssrn.com/abstract=2291869

Electronic copy available at: http://ssrn.com/abstract=2291869

BL select comparable firms using the fitted value of a regression of multiples on 8

3. A model of valuation using multiples

X 0T / PˆT  w1m1  w2 m2 (5)

Where mi  X 0i / Pi is the cash-flow-to-price multiple of firm i (i.e. the inverse of the

5.1 Choice of comparables and weighting scheme

The valuation model we have presented results in a procedure whereby comparable

We define the valuation error for firm i at time t by:

VEit  ( Pit / Pˆit )  1  (M it / Mˆ it )  1 (7)

5.2 Mismatching of characteristics

As a further test of the relevance of these omitted characteristics we examine the

VET ,t  VET ,t  at 1   b j ,t 1CT , j ,t (10)

characteristics for target firm T measured at time t.

5.3 Omitted but persistent characteristics

VEi,t = a + b*VEi,t-1 + ei,t (11)

Table 5 reports the result of this regression.7

5.4 Biases in earnings forecasts

5.5 Industry-specific multiples

6.1 Predictability of valuation errors and stock returns

6.2 Predictable revisions in earnings forecasts

We have developed a new theory of equity valuation using multiples, based on

Define ci  (Ci / Pi ) is the scaled index of characteristics of firm i. Rearrange (A1.5) to

One simple solution to (A1.6) is to pick an equal number of comparables with

wi  1/ ABS (di ) where di  (ci  cT ) .

Let Rt 1,t be the rate of return between t-1 and t. By definition:

Using the fact that Pt  M t Et :

Rt 1,t  (M t Et / M t 1Et 1 )*[( Pt  Dt ) / Pt ] (A2.4)

Taking logs of (A2.4) and using:

Baker, M. and R. Ruback. 1999. Estimating industry multiples. Harvard University

Damodaran, A. 2002. Investment Valuation. Wiley Finance.

Ohlson, J. 1995. Earnings, book values, and dividends in equity valuation.

Panel C: With BL restrictions

1983 0.005 -1.689 0.004 -0.008 0.330 0.000 9.79%

1983 0.002 -1.110 0.000 -0.008 0.250 0.013 3.95%

PANEL B (adjusted by differences in characteristics)

Unweighted harmonic Mean (all in

const b Adjusted const b Adjusted

1983 0.018 0.624 37.95% 1983 0.014 0.608 32.83%

PANEL B (adjusted by lagged valuation error)

Panel A: No lag error adjustment

Panel B: Lag error adjustment

Dependent variable Const b Adjusted

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