Employing Ideal Vs Ad Hoc

Equity Valuation Employing the Ideal versus Ad Hoc Terminal Value Expressions*
LUCIE COURTEAU, Universit Laval JENNIFER L. KAO, University of Alberta GORDON D. RICHARDSON, University of Waterloo Abstract
Recently, Penman and Sougiannis (1998) and Francis, Olsson, and Oswald (2000) compared the bias and accuracy of the discounted cash ow model (DCF) and Edwards-Bell-Ohlson residual income model (RIM) in explaining the relation between value estimates and observed stock prices. Both studies report that, with nonprice-based terminal values, RIM outperforms DCF. Our rst research objective is to explore the question whether, over a ve-year valuation horizon, DCF and RIM are empirically equivalent when Penmans (1997) theoretically ideal terminal value expressions are employed in each model. Using Value Line terminal stock price forecasts at the horizon to proxy for such values, we nd empirical support for the prediction of equivalence between these valuation models. Thus, the apparent superiority of RIM does not hold in a level playing eld comparison. Our second research objective is to demonstrate that, within each class of the DCF and RIM valuation models, the model that employs Value Line forecasted price in the terminal value expression generates the lowest prediction errors, compared with models that employ nonprice-based terminal values under arbitrary growth assumptions. The results indicate
* Accepted by Jerry Feltham. This paper was presented at the 2000 Contemporary Accounting Research Conference, generously supported by the CGA-Canada Research Foundation, the Canadian Institute of Chartered Accountants, the Society of Management Accountants of Canada, the Certied General Accountants of British Columbia, the Certied Management Accountants Society of British Columbia, and the Institute of Chartered Accountants of British Columbia. We would like to thank workshop participants at the 2000 American Accounting Association meetings; 2000 Canadian Academic Accounting Association Conference; 2000 Contemporary Accounting Research Conference; 2000 European Accounting Association Conference; HEC, Laval; University of Queensland, University of TechnologySydney; and University of Waterloo for their comments. Special thanks are extended to Sati Bandyopadhyay, Joy Begley, Brian Bushee, Peter Clarkson, Steve Fortin, Kin Lo, Russell Lundholm (the discussant), Pat OBrien, Terry OKeefe, Steve Penman, Ranjini Sivakumar, Theodore Sougiannis, Ken Vetzal, and especially Jerry Feltham (the editor) for their helpful comments and suggestions on earlier versions of the paper; Kendrick Fiorito and Mort Siegel at Value Line for their advice on the project; Nick Favron for programming assistance; and Daniel Roy and Nicole Sirois for their excellent research assistance. The research is supported by the Social Sciences and Humanities Research Council of Canada and the Canadian Academic Accounting Association. Jennifer Kao also receives nancial support from Canadian Utilities Fellowship for this project. All remaining errors are the authors sole responsibility.
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that, for both DCF and RIM, price-based valuation models outperform the corresponding non price-based models by a wide margin. These results imply that researchers should exercise care in interpreting ndings from models using ad hoc terminal value expressions. Keywords Financial information; Residual income model; Terminal values; Valuation
Condens
Penman et Sougiannis (1998, ci-aprs P&S) comparaient rcemment la distorsion et la prcision du modle dactualisation des ux de trsorerie (DCF) et du modle des bnces rsiduels dEdwards, Bell et Ohlson (RIM) dans lexplication de la relation entre les estimations de valeur et le cours observ des actions. Utilisant les bnces futurs rels comme mesure des bnces attendus, P&S (1998) constatent que les erreurs dvaluation du modle DCF sur un horizon de 10 ans excdent largement celles du modle RIM. Ils attribuent ce rsultat au fait que des montants comptabiliss conformment aux PCGR dans le modle RIM permettent une prise en compte plus rapide de ux de trsorerie futurs, de sorte que leur pertinence lgard de la valeur est plus grande que celle des ux de trsorerie ou des dividendes. Francis, Olsson et Oswald (2000) jettent un nouveau regard sur ce parallle, en recourant une mthode ex ante et aux prvisions de Value Line (VL), pour conclure leur tour que, lorsque les valeurs nales ne sont pas fondes sur les prvisions du cours des actions, lefcacit du RIM est suprieure celle du DCF. Le premier objectif des auteurs est de vrier si, sur un horizon prvisionnel de cinq ans, le DCF et le RIM sont empiriquement quivalents, lorsquon utilise les expressions de valeur nale thoriquement idales de Penman (1997), dans lapplication de chacun des modles. Ces expressions de valeur ncessitent le cours du march prvu (P ) au terme de lhorizon prvisionnel et lexcdent de ce cours sur la valeur comptable, pour un systme comptable donn. Lquivalence des modles DCF et RIM pour des horizons nis et dans des conditions idales, malgr quelle soit bien tablie en thorie, na pas t dmontre dans les tudes empiriques. Au premier abord, les arguments semblent circulaires : si des prvisions ables de cours sont disponibles, le modle dactualisation des dividendes (DDM) devrait sufre, et il nest pas ncessaire de recourir au DCF ou au RIM. La chose nest cependant pas vidente, du fait que les prvisions de cours formules par le march ne sont pas observables ; les auteurs utilisent donc les prvisions de cours nal de VL comme substitut. Bien que ces prvisions soient loin dtre idales et quelles puissent contenir des erreurs de distorsion ou de mesure (voir Abarbanell et Bernard, 2000), les auteurs font lhypothse que toute erreur de distorsion ou de mesure serait un facteur constant dans les comparaisons entre DCF et RIM. Ils supposent galement, comme P&S (1998) et Francis et al. (2000), que le march est efcient. Le deuxime objectif des auteurs consiste dmontrer que les valeurs intrinsques calcules laide des prvisions de cours nal de VL donnent lieu des erreurs dvaluation plus modestes que les valeurs intrinsques dtermines en fonction des expressions de valeur nale improvises. Les expressions simples de perptuit, qui supposent que les bnces anormaux postrieurs lhorizon prvisionnel crotront soit au taux de 0 pour cent, soit au taux nominal dination, ont t amplement utilises dans les recherches empiriques (par Francis et al., 2000, et par Frankel et Lee, 1998, entre autres). Gebhardt, Lee et Swaminathan (2001) utilisent un procd de taux de dcroissance qui est aussi problmatique que CAR Vol. 18 No. 4 (Winter 2001)
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les expressions bases sur la perptuit, tant donn quil suppose que le rendement anormal du capital investi postrieur lhorizon prvisionnel convergera vers la moyenne du secteur dactivit, sur une priode de sept ans. Les auteurs constatent que les valeurs nales sont en moyenne sensiblement sous-values lorsque des estimations improvises de lachalandage au terme de lhorizon prvisionnel sont utilises, ce qui suppose que les estimations de la valeur intrinsque (Frankel et Lee, 1998) ou du cot du capital ex ante (Gebhardt et al., 2001) sont sous-values lorsque de telles expressions de valeur nale sont employes. Ces infrences peuvent tre importantes, selon le but vis par la recherche, et elles demeurent valides mme dans les dernires annes de la priode tudie, une fois que sest attnu loptimisme de VL dans les prvisions de cours. Lchantillon des auteurs compte 422 socits (ou 2 110 exercices-socit), lgard desquelles ils disposent de donnes prvisionnelles et historiques compltes pour toute la dure de la priode couverte. Le fait que lchantillon soit constant et que les mesures se rptent au l dune priode donne pour les mmes socits retient lattention des auteurs qui empruntent la mthodologie de lchantillon constant (voir Kmenta, 1986) exploitant les autocorrlations dans les donnes pour raliser certains tests statistiques. Le cot des capitaux propres est calcul laide du modle dvaluation des actifs nanciers. Le taux sans risque est mesur comme tant le taux constant lchance des bons du trsor de cinq ans, au dbut du mois de prvision, provenant de la base de donnes de la Chicago Federal Reserve Bank, et la prime de risque est mesure comme tant le produit du bta de lentreprise fourni par VL et de la prime de march historique approximative de 6 pour cent. Les auteurs utilisent les premires prvisions compltes de VL, habituellement publies au troisime trimestre de lexercice de lentreprise. linstar de Francis et al. (2000), les auteurs actualisent les prvisions de VL pour les attributs dvaluation du n e exercice en utilisant un facteur de (n 1 + f ), o f reprsente la portion dexercice se situant entre la date o sont faites les prvisions et la clture du premier exercice. tant donn que tous les modles dvaluation exigent des valeurs comptables la date de la prvision, ce que VL ne fournit pas directement, il faut intrapoler les valeurs comptables (les actifs nanciers nets) cette date pour le RIM (le DCF), partir de leur valeur au dbut de lexercice de prvision et des prvisions de VL relatives aux variables de lexercice courant. VL publie des prvisions pour trois horizons : lexercice en cours (soit lexercice 1), lexercice suivant (soit lexercice 2) et le long terme (soit lexercice 5). tant donn que les prvisions annuelles des attributs dvaluation pour les exercices 3 et 4 ne sont pas publies dans le Value Line Investment Survey, la suggestion des analystes de VL, les auteurs intrapolent de faon linaire les donnes relatives ces deux exercices, en fonction de la croissance prvue entre lexercice 2 et lexercice 5. Le cours le plus rcent rapport par VL est utilis dans cette tude comme variable dpendante. Dans le cas du RIM comme dans celui du DCF, le chercheur doit parfois faire face la situation o les valeurs nales sont ngatives. Le cas peut se produire si lun ou lautre des excdents prvus du cours sur la valeur comptable, compte tenu des prvisions de cours nal ou des attributs de lvaluation au terme de lhorizon prvisionnel, est ngatif. Les auteurs choisissent de ne pas plafonner les valeurs nales ngatives zro parce que tout attribut ngatif au terme de lhorizon prvisionnel devrait tre intgr dans le cours du march en vigueur. Les tests statistiques rvlent que, pour lensemble de lchantillon, les erreurs prvisionnelles absolues mdianes sont de 13,71 pour cent et de 14,18 pour cent respectivement CAR Vol. 18 No. 4 (Winter 2001)
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pour le DCF et le RIM. Ainsi, en mettant laccent sur la prcision, on ne constate pas de supriorit du RIM sur le DCF lorsque les valeurs nales idales sont employes. Toute mise lpreuve du RIM et du DCF risque de placer ce dernier en situation dfavorable en raison des limites inhrentes lestimation de la version de Copeland et al. (1995) du modle nancier des ux de trsorerie disponibles, une mthode employe par Francis et al. (2000) qui fait appel aux donnes de VL. Pour rsoudre ce problme, les auteurs estiment la version du DCF propose par Penman (1997). Cette spcication particulire convient mieux aux donnes de VL parce que lattribut dvaluation les ux de trsorerie disponibles aux actionnaires ordinaires peut tre tir directement des donnes VL et quil nest pas ncessaire destimer le cot moyen pondr du capital. Les auteurs formulent nanmoins une mise en garde : lapplication de la version du DCF propose par Penman, qui fait un usage empirique des donnes de VL, peut encore contenir des erreurs de mesure tant donn que VL ne fournit pas de prvisions relatives aux impts sur le revenu reports ou aux sommes immobilises dans le fonds de roulement. Compte tenu de ces limitations pratiques de lestimation du DCF, il est assez remarquable davoir pu tablir une quivalence approximative entre le DCF et le RIM. Mettant en opposition les valeurs intrinsques des modles qui utilisent les prvisions de cours nal et les valeurs intrinsques des modles qui ne le font pas, les auteurs constatent que, tant pour le DCF que pour le RIM, lefcacit des modles dvaluation bass sur les prvisions de cours surpasse de beaucoup celle des modles correspondants qui ne sappuient pas sur les cours. Bien sr, lutilisation des prvisions de cours VL comme point de repre nest pas valide si ces prvisions sont optimistes. Toutefois, mme pour les deux dernires annes incluses dans ltude (1995 1996), au moment o loptimisme des prvisions de cours de VL se trouve ramen un niveau ngligeable, lerreur prvisionnelle mdiane continue dindiquer une importante distorsion la baisse lorsque les expressions improvises de valeur nale sont utilises. Ces rsultats donnent penser que les chercheurs qui tudient le cot du capital ex ante ou les stratgies dinvestissement faisant appel aux expressions simplies de valeur nale pour le RIM devraient interprter leurs rsultats avec une certaine prudence. En remplaant les prvisions de cours nal de VL par des expressions traditionnelles de valeur nale laide destimations de croissance simples, semblables celles quemploient P&S (1998) et Francis et al. (2000), les auteurs sont en mesure de reproduire les constatations prcdentes selon lesquelles le RIM surpasse le DCF en efcacit. Ainsi, dans la rgression des cours en vigueur en fonction des valeurs intrinsques, la valeur de R2 est suprieure dans le cas du RIM comparativement au DCF (par exemple, 79,65 pour cent contre 67,95 pour cent, et 77,02 pour cent contre 60,46 pour cent, lorsque les hypothses de croissance sont respectivement de 0 et de 2 pour cent). La supriorit du RIM sur le DCF lorsque la valeur nale idale nest pas disponible est explique par P&S (1998) dans les termes suivants : la valeur comptable actuelle des capitaux propres inclut dj une partie des ux de trsorerie futurs et laisse relativement peu de valeur encaisser au terme de lhorizon prvisionnel. Par exemple, selon lhypothse de croissance de 0 pour cent (2 pour cent), 20,77 pour cent (25,53 pour cent) de la valeur intrinsque dans le cas du RIM est drive de la valeur nale actualise, le chiffre correspondant dans le cas du DCF tant de 91,81 pour cent (93,19 pour cent). Lundholm et OKeefe (2001, ci-aprs L&O) relvent des erreurs dans lapplication des modles du RIM et du DCF qui se soldent par des estimations incohrentes de la valeur CAR Vol. 18 No. 4 (Winter 2001)
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intrinsque. Bien que leurs travaux mettent surtout en relief limportance dviter ces cueils, L&O afrment que lquivalence du RIM et du DCF est assure . Lquivalence du RIM et du DCF lorsquon emploie les expressions de valeur nale idale, ne peut se conrmer que si 1) la mme prvision des cours de VL est utilise dans les deux modles et si 2) le chercheur vite les cueils voqus par L&O. Lun des cueils quvoquent L&O, sans proposer de solution pratique, est celui de la difcult de lestimation du cot moyen pondr du capital pour le modle DCF. La version Penman du modle DCF utilise par les auteurs minimise le risque derreurs dans lapplication du modle DCF et nexige pas lestimation du cot moyen pondr du capital. Fait dgale importance, elle ne fait pas intervenir lhypothse traditionnelle des versions empiriques prcdentes du modle des ux de trsorerie disponibles selon laquelle les actifs nanciers nets sont comptabiliss la valeur du march. Sils ne le sont pas, le chercheur doit enrichir le modle traditionnel des ux de trsorerie disponibles en y ajoutant un terme qui reprsente la diffrence entre la juste valeur et la valeur comptable des actifs nanciers nets. Sans ce terme, lquivalence entre le DCF et le RIM ne peut tre dmontre. Un autre des apports de cette tude est quelle indique aux chercheurs comment rduire au minimum les incohrences dans lestimation des valeurs intrinsques grce lutilisation des donnes de VL dans lapplication du modle DCF. Les questions de recherche de cette tude ont une pertinence pratique. Lquivalence du DCF et du RIM est tenue pour acquise par ceux et celles qui tudient lanalyse des tats nanciers, et la dmonstration empirique de cette quivalence est utile. Bien sr, dans le cas dun horizon ni, lquivalence nest possible quavec des prvisions de cours nal, faute de quoi il convient de dterminer avec soin la longueur de lhorizon prvisionnel et la forme de lexpression de la valeur nale axe sur les cours, ainsi que lont dmontr les travaux antrieurs.
1. Introduction Recently, Penman and Sougiannis (1998; hereafter P&S) compared the bias and accuracy of the discounted cash ow model (DCF) and Edwards-Bell-Ohlson residual income model (RIM) in explaining the relation between value estimates and observed stock prices. Using a perfect foresight approach, P&S nd that valuation errors for DCF over a 10-year horizon exceed those of RIM by a substantial margin. They attribute this result to generally accepted accounting principles (GAAP)-based accounting accruals under RIM, which bring future cash ows forward and hence are more value-relevant than either cash ows or dividends. Francis, Olsson, and Oswald (2000) take a second look at that comparison using an ex ante approach and Value Line (VL) forecasts and also conclude that with non price-based terminal values RIM outperforms DCF. Our rst research objective is to explore whether, over a ve-year valuation horizon, DCF and RIM are empirically equivalent using Penmans (1997) theoretically ideal terminal value expressions in each model. These expressions require the markets expected stock price (P) at the horizon and the premium of that price over book value for a particular accounting system. The equivalence of DCF and RIM for nite horizons under ideal conditions, though well established theoretically, has not been demonstrated in the empirical literature. At rst glance, the arguments seem circular: if one has reliable price forecasts, the dividend discount
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model (DDM) should sufce and one does not need DCF or RIM. However, the point is not obvious because the markets stock price expectations are not observable, and we use VLs terminal stock price forecasts as a surrogate. Although VL terminal price forecasts are far from ideal and may contain bias/measurement error (see Abarbanell and Bernard 2000), we invoke the assumption that any bias/ measurement error will be a constant factor in comparisons across DCF and RIM. Market efciency is a maintained assumption in our study, as it is in P&S 1998 and Francis et al. 2000. Our second research objective is to demonstrate that intrinsic values calculated using VL terminal stock price forecasts produce smaller valuation errors than intrinsic values employing ad hoc terminal value expressions. Simple perpetuity expressions that assume that post-horizon abnormal earnings will grow at either a rate of 0 percent or the rate of nominal ination have been widely employed by empirical researchers (e.g., Francis et al. 2000 and Frankel and Lee 1998). Gebhardt, Lee, and Swaminathan (2001) use a fade rate procedure that is also ad hoc in that it assumes that post-horizon abnormal return on equity will converge to the industry average over a seven-year period beyond the forecast horizon. We nd that terminal values are on average substantially understated using ad hoc estimates of horizon goodwill, implying that estimates of intrinsic value (Frankel and Lee) or the ex ante cost of capital (Gebhardt et al.) are understated when ad hoc terminal value expressions are used. These inferences can be important depending on the intended research purpose, and hold even in the latter years of our sample when the optimism in VL stock price forecasts has abated. Lundholm and OKeefe (2001, hereafter L&O) identify errors in application of the RIM and DCF models that lead to inconsistent estimates of intrinsic value. While much of their paper emphasizes the importance of avoiding these pitfalls, L&O assert that the equivalence of RIM and DCF is guaranteed to hold. The equivalence of RIM and DCF employing ideal terminal value expressions will only hold if (1) the same VL price forecast is used in RIM and DCF; and (2) the researcher avoids the pitfalls discussed in L&O. One pitfall that L&O refer to, but offer no practical suggestion for, is the conundrum of estimating the weighted average cost of capital for the DCF model. We introduce into the empirical literature a version of DCF derived by Penman 1997 that minimizes the potential for errors in applying the DCF model. Specically, our version of DCF does not require estimates of the weighted average cost of capital (i.e., WACC) and, just as important, it does not invoke the assumption typical of prior empirical versions of the free cash ow model that net nancial assets are marked to market. If nancial assets are not marked to market, then the researcher must augment the traditional free cash ow model by incorporating a term representing the fair value increment on current net nancial assets. If this term is missing, the equivalence across DCF and RIM cannot be demonstrated. Thus, another contribution of our study is to show researchers how to minimize inconsistent estimates of intrinsic values using VL data to estimate the DCF model. Our research questions have practical importance. The equivalence of DCF and RIM is something students of nancial statements analysis take on faith and
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the empirical demonstration of this equivalence is useful. Of course, for a nite horizon, the equivalence is possible only with terminal stock price forecasts. Without such forecasts, careful attention must be paid to the length of the forecast horizon and the form of the nonprice-based terminal value expression, as prior literature has shown. We inherit the focus on pricing errors and the maintained assumption of market efciency from the horse race conducted by P&S 1998 and Francis et al. 2000. Our aim is to revisit the setting of these studies and set the record straight on the apparent superiority of RIM over DCF, employing a level playing eld where both models use an approximation of ideal terminal values. The pricing error approach seemingly conicts with the rationale for VL and fundamental analysis that is, to spot mispriced securities. In section 6, we provide suggestions for further research focusing on future excess returns. The remainder of this study is organized as follows. A literature review is provided in section 2. Section 3 lays out the research methodology and hypotheses. The sample selection and measurement issues are discussed in section 4, and the empirical results are presented in section 5. Finally, our summary and conclusions appear in section 6. 2. Literature review The DDM and DCF models are well-known approaches to valuation in the nance literature (see Cornell 1993; Copeland, Koller, and Murrin 1995). RIM is discussed extensively by Ohlson 1995, who shows that theoretically GAAP book values and earnings are valid valuation attributes. Feltham and Ohlson (1995) establish the theoretical equivalence of DDM, DCF, and RIM for innite valuation horizons. All three models follow from the familiar present value of expected dividends (PVED) expression for value, and the last two models substitute out dividends in PVED for relevant valuation attributes.1 Penman (1997) establishes the theoretical equivalence of DDM, DCF, and RIM for nite valuation horizons, provided one that has access to data necessary to estimate the following ideal terminal values at the end of forecast horizon T: E t (Pt + T) for DDM; E t (P B) t + T for RIM; and E t (P FA) t + T for DCF. In the above, E t () denotes market expectations at time t; Pt + T and Bt + T denote forecasted stock price and book value of owners equity at the horizon T periods hence; and FA t + T denotes forecasted net nancial assets at the horizon. In his paper, Penman does not anticipate that the researcher would have access to forecasts of stock price at the horizon, and hence much of his paper discusses possible estimates of terminal values for each of the DDM, DCF, and RIM models when forecasted stock price is unavailable. One of the objectives of our research is to establish Penmans hypothesized equivalence over a ve-year forecast horizon using VL proxies for the above ideal terminal values. A potential limitation of this approach is that market expectations can be measured with error using VL forecasts of future stock price and other valuation attributes. An extensive literature exists that suggests that VL earnings forecasts are biased and/or inefcient (see Abarbanell 1991; Abarbanell and Bernard 1992; and Debondt and Thaler 1990). In a similar vein, Botosan
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(1997) observes that the optimism in VLs terminal price forecasts yields implausibly high estimates of the equity cost of capital. On the other hand, other researchers have shown that the accuracy of VL forecasts and their association with stock price changes are comparable to those of other analysts, such as I/B/E/S and Zacks (see Abarbanell 1991; Bandyopadhyay, Brown, and Richardson 1995; Philbrick and Ricks 1991; and Stickel 1992). The advantages of VL forecasts over I/B/E/S are that VLs long-run target price range yields forecasts of stock price at the horizon ve years hence, and no similar price forecasts exist in I/B/E/S. Moreover, VL forecasts dividends, earnings, book values, and future cash ows separately; whereas only forecasts of earnings are available in I/B/E/S.2 Forecasts of dividends and book values are required by RIM, and forecasts of future free cash ows are required by DCF. Although VL provides estimates of long-run target price range, neither point nor range estimates of short-run stock price are made. However, in the Value Line Investment Survey, VL publishes a timeliness rank, which is based on a mechanical model (see Foster 1986, 4302, for details) and represents expected price appreciation over the next 12 months. Many studies have shown that, using VLs timeliness measure, investors can earn abnormal returns around a three-day publication period (e.g., Copeland and Mayers 1982; Huberman and Kandel 1987). Similarly, Peterson (1995) nds that publication of stock highlights by VL elicits positive abnormal returns. Since VLs long-run target price ranges come from the same underlying data set that generates timeliness ranks and stock highlights, they can be taken seriously even though their usefulness has not been established in the prior literature. In section 4, we elaborate on how VL constructs these long-run target price ranges. In the empirical domain, P&S (1998) and Francis et al. (2000) are the direct antecedents of our work. P&S use a perfect foresight approach and nd that valuation errors for DCF over a 10-year horizon are often in excess of 100 percent and, moreover, these errors consistently exceed those of RIM by a substantial margin. This result, according to P&S, may be due to GAAP-based accounting accruals under RIM, which bring future cash ows forward, compared with the DCF model, which expenses investment outlays. Francis et al. revisit the issue of model comparison from an ex ante perspective using VL forecasts over a 5-year horizon, and similarly conclude that RIM dominates over DCF. Like Francis et al., we also take an ex ante approach to study the relative performance of RIM and DCF. However, in contrast to Francis et al., we make use of VL terminal stock price forecasts in calculating terminal values for each model, thus avoiding the need either to extrapolate such values from near-term valuation attributes or to assume an ad hoc growth rate, which may or may not correspond to market expectations. Three other extant empirical studies have also employed an ex ante approach to explore the valuation errors associated with RIM. Bernard (1995) uses VL forecasts of (P B) at the horizon ve years hence to measure terminal value, and shows that the intrinsic values for RIM explain 80 percent of the cross-sectional variation in the level of current stock price. Abarbanell and Bernard (2000) examine the importance that the market attaches to the present value of terminal forecasts of (P B), and nd its regression coefcient to be around 0.67, considerably below
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the predicted value of unity.3 This result is consistent with the notion that VL terminal price forecasts contain bias/measurement error. Finally, Sougiannis and Yaekura (2001) explore the valuation errors associated with several GAAP-based RIM valuation models using I/B/E/S rather than VL forecast data. For RIM with conventional non price-based terminal value expressions at a horizon ve years hence, they obtain median signed (absolute) valuation errors of 26 (35) percent. As we will see later, the magnitudes of these errors are comparable to our RIM errors for valuation estimates that do not employ VL terminal stock price forecasts.4 3. Research methodology and hypotheses development Valuation models In this section, we develop the two major classes of valuation models to be tested in the paper, namely, DCF and RIM, by appealing to Penman 1997. These models are based on the following well-known present value of expected dividend model (PVED) for an innite horizon:
Pt =
=1
Et ( d t + )
(1),
where Pt is the current market price at time t; R denotes one plus the cost of equity capital; dt + denotes dividends for each future period, t + ; and Et indicates an expectation conditional upon information available at time t . Penman (1997) shows that when the horizon is nite, the intrinsic value, denoted as Wt, under DDM for T periods hence is given by:
Wt (DDM ) =
=1
E t ( d t + ) + R T Et(Pt + T)
(2),
where Pt + T is the markets forecasted price at the horizon, t + T. It is an ideal terminal value for DDM. DCF model The following clean surplus relation (CSR) is assumed to hold for net nancial assets at time t + , t = 1, 2, , T : FA t + = FA t +
1
+ Ct + It + + it + dt +
(3),
where for each future period t + , FA denotes net nancial assets (i.e., cash and marketable securities minus debt and preferred equity) and is negative if there is net debt; (C I ) is operating cash ows minus capital expenditures (i.e., free cash ows generated by operating assets); and i is interest ow from net financial assets,
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which represents interest paid (earned), including preferred dividends, if net nancial assets are negative (positive). Bringing d t + to the left-hand side of (3) and all other expressions to the right, and substituting for E t (d t + ) in equation (1), Penman (1997) derives the following version of the DCF model for an innite horizon:
Wt (DCF ) = FA t +
=1
E t [C t + I t + + i t + (R 1) FA t +
1]
(4).
It is important to note that (4) assumes only PVED and CSR for net nancial assets, and one can easily revert back to PVED by substituting in the opposite direction. As explained by Feltham and Ohlson 1995, (4) represents the cash accounting model where operating assets are expensed; book value is represented by current net nancial assets; and earnings are represented by free cash ows from operations, (C I ), plus (minus) interest income (expense), i. Penman (1997) shows that if one relaxes the assumption of risk neutrality but assumes that net nancial assets are marked to market at all times, (4) becomes the familiar free cash ow model:
Wt (DCF ) = FA t +
=1
RW Et (C t + I t + )
(5),
where RW denotes one plus the weighted average cost of capital (i.e., WACC). The equation states that the value of owners equity equals the sum of the fair values of net nancial assets and net operating assets, with the latter represented by the present value of expected future free cash ows.5 Francis et al. (2000) estimate variations of (5). We prefer Penmans version of the DCF (i.e., (4)) for several reasons. First, (5) requires the estimation of WACC, where the weights must be based on the estimated value of equity and debt, not on either their book value or a target capital structure. On the other hand, (4) requires the equity cost of capital, thus placing DCF on an equal footing with RIM. Second, (5) assumes that FAs are marked to market and, to the extent that fair value does not equal book value, it introduces noise in the intrinsic value expressions. By comparison, (4) does not make that assumption, and implicitly corrects for any fair value increment on debt.6 Finally, (5) requires forecasted operating cash ows (i.e., C I ), which, unlike forecasts of free cash ows to common (i.e., C I + i ), are not provided by VL. To derive C I, one needs to remove the effects of interest expense (income), i. This is problematic because VL does not provide forecasts of i to the horizon for either debt or preferred shares. For an arbitrary nite horizon T, Penman (1997) shows that the ideal terminal value for a nite horizon version of (4) is the markets expected premium, (P FA), at the forecast horizon. The following equation represents our DCF model employing VL forecasted price in the terminal value expression:
635
Wt (DCF 1) = FA t +
=1
E t [C t + I t + + i t + (R 1) FA t +
1]
+ R T Et (Pt + T FA t + T)
(6a).
The expression (Pt + T FAt + T) at the horizon captures the present value of posthorizon operating cash ows because the cash accounting model expenses operating assets. It also captures any post-horizon fair value increment, if net nancial assets are not marked to market. When a terminal stock price forecast is not available, it is of interest to explore other nonprice-based expressions. Following Frankel and Lee 1998, P&S 1998, and Francis et al. 2000, we employ two expressions: one assumes a simple perpetuity without growth and the other assumes a perpetuity with constant growth rate g = 2 percent.7 Modifying (6a) accordingly results in:
Wt (DCF 0) = FA t +
=1
E t [C t + I t + + i t + (R 1) FA t +
1]
+ RT (R 1) 1E t [C t + T + 1 I t + T + 1 + i t + T + 1 (R 1) FA t + T ]
(6b);
Wt (DCF 2) = FA t +
=1
E t [C t + I t + + i t + (R 1) FA t +
1]
+ RT (R 1 g) 1E t [C t + T + 1 I t + T + 1 + i t + T + 1 (R 1) FA t + T ] We compute the numerator of the ad hoc terminal value expression as
(6c).
[C t + T + 1 I t + T + 1 + i t + T + 1 (R 1)FA t + T] = (1 + g) (C t + T I t + T + i t + T) (R 1)FA t + T. For the purposes of estimating (6a)(6c), and (7a)(7c) discussed next, all variables are deated by the number of shares outstanding at the end of forecast year.8 RIM model Penman (1997) shows that, for a nite horizon T, the ideal terminal value for RIM is the markets expected premium, (P B), at the forecast horizon. This expression represents the present value of post-horizon abnormal earnings (i.e., subjective goodwill) and reects the joint effects of positive net present value projects and accounting conservatism. Since VL explicitly forecasts book value ve years hence, the expected premium can be calculated to yield the following best contender from the RIM family of valuation models:
636
Wt (RIM 1) = Bt +
=1
a
E t ( X t + ) + R T E t (Pt + T B t + T )
(7a),
where X t + denotes abnormal income for forecast year t + , measured as VLs forecasted net income minus a charge on the capital employed (i.e., R 1 times opening B ). The corresponding expressions that do not employ terminal price forecasts are:
T
Wt (RIM 0) = B t +
=1
T
E t ( X t + ) + R T(R 1) 1 Et( X t + T + 1)
(7b),
Wt (RIM 2) = Bt +
=1
a
E t ( X t + ) + R T(R 1 g) 1 Et( X t + T + 1)
(7c),
where X t + T + 1 = (1 + g) Xt + T (R 1) Bt + T , under the assumptions of a simple perpetuity with constant growth. Hypotheses development Following P&S 1998 and Francis et al. 2000, we focus on comparing the signed and absolute prediction errors across DCF and RIM. We do not consider DDM in this paper because our price-based DCF model (i.e., (6a)) is developed directly from the corresponding DDM (i.e., (2)) given the nancial assets continuity account (i.e., (3)) for each pre-horizon year, thus guaranteeing their theoretical and empirical equivalence.9 The empirical comparison between DCF and RIM that employ Penmans 1997 ideal price-based terminal value expressions (i.e., (6a) and (7a)) is, however, complicated by the presence of several additional sources of inconsistency, which may or may not be easily avoided by the researcher, as discussed in the introduction and elaborated further in section 5. The equivalence of these two models is not guaranteed empirically unless errors in implementing each model are carefully considered and minimized. We conjecture that, in the absence of implementation errors, the choice between DCF and RIM should be a matter of indifference. This is formalized in our rst hypothesis (stated in the null form): HYPOTHESIS 1. Across the versions of DCF and RIM that employ VL forecasted price in the terminal value expression, there is no difference in prediction errors. We next compare non priced-based models under 0 percent and 2 percent constant growth assumptions with the corresponding price-based models within the same class of DCF and RIM. We expect the model that uses VLs price forecasts in
637
the terminal value expressions (i.e., (6a) and (7a)) to beat other contenders within their class (i.e., (6b) (6c) for DCF; and (7b) (7c) for RIM). Intuitively, if the researcher cannot observe VLs post-horizon expectations, any non price-based terminal value calculated under an arbitrary growth assumption is at best ad hoc. The above discussion leads to our second hypothesis (stated in the alternative form): HYPOTHESIS 2. Within each class of the DCF and RIM valuation models, the model that employs VL forecasted price in the terminal value expression generates the lowest prediction errors, compared with models that employ non price-based terminal value under arbitrary (0 percent and 2 percent) growth assumptions. It is worthwhile pointing out that Hypothesis 2 is also not guaranteed empirically. For example, if VLs price forecasts are pure noise or if VL simply applies the reciprocal of the equity cost of capital at the horizon and multiplies this by forecasted earnings ve years hence, then the forecasted price would fail to capture subjective goodwill beyond the horizon. In this case, (7a) will have no edge over (7b) or (7c),10 and the superiority result predicted in Hypothesis 2 is generally not assured. 4. Data description and measurement issues Data description Our initial sample consists of 500 rms (or 2,500 rm-year observations), which were followed by VL over a ve-year period, 199296, and were on both CRSP and COMPUSTAT during that time. This sample size is chosen for practical considerations because the forecasts of prices, book values, dividends, cash ows, and other relevant accounting valuation attributes are not available from machinereadable sources and must be hand-collected from the archived Value Line Investment Survey. To draw the sample, we rst obtain an intersection of 1,089 rms, excluding those in the nancial services sector, from the 1996 coverage of VL, CRSP, and COMPUSTAT, and then apply a random number generating procedure. We require ve years of forecast data for all rms included in the sample. Nonforecast-related historical data are extracted from the Value Line Data File. Due to missing data in the data le, 36 rms are eliminated, 41 rms are dropped because VLs annual capital investment estimates are not provided for some industries,11 and another rm is deleted because VL did not provide price forecasts for one of the years (i.e., 1996). This leaves us with a nal sample of 422 rms (or 2,110 rm-years), each with complete forecasted and historic data over the entire sample period under investigation. The panel nature of the data with repeated measures over calendar time for the same rms appeals to us, and panel data methodology (see Kmenta 1986) exploiting autocorrelations in the data will be used for formal statistical tests. Our sample rms are large, with mean (median) market capitalization of $4.95 ($1.18) billion. The minimum market capitalization is $25.80 million, and the
638
maximum is $16.87 billion. Firm-specic betas provided by VL range from a low of 0.05 to a high of 2 with the mean beta given by 1.02. The equity cost of capital is computed based on the CAPM. The riskless rates are measured as the ve-year treasury constant maturity rates at the beginning of the forecast month from Chicago Federal Reserve Bank data base and the risk premiums are measured as the product of VL rm-specic betas and the approximate historical equity premium of 6 percent.12 The cost of equity has a mean of 12.28 percent and the minimum and maximum of 5.69 percent and 18.64 percent, respectively. Measurement issues To measure the variables described in (6a)(6c) and (7a)(7c) for each of the ve sample years, we take the rst complete published VL forecasts, which typically appear in the third quarter of the rms scal year. Following Francis et al. 2000, we discount VL forecasts of the n th years valuation attributes by a factor of (n 1 + f ), where f reects the fraction of year between the market valuation date and the rst scal year-end.13 Since all the valuation models require book values at the date of forecast, which VL does not directly provide, we need to interpolate book values (net nancial assets) to the forecast date for the RIM (DCF) models based on their values at the beginning of forecast year and the VL forecasts of related current scal years variables.14 Our conversations with VL personnel indicate that VL analysts predictions of the target stock price range, three to ve years ahead, are not mechanical. Judgement is required of the analyst at three stages in constructing the target price range. First, judgement is used to forecast projected earnings three to ve years ahead. Second, judgement is used in applying the appropriate P/E ratio to forecasted earnings, and the P/E ratio can deviate from the projected average P/E ratio for the market according to the analysts long-term growth projections for the stock in question. Third, judgement is applied in selecting one of ve possible range categories to surround a point estimate of forecasted price, with smaller ranges associated with greater nancial strength/safety as assessed by the VL analyst and her supervisors. We conclude from these conversations that the width of target stock price ranges reects uncertainty, and that such price forecasts impound the VL analysts growth assumptions beyond the horizon. For our purposes, we dene the terminal price forecasts, Pt + T , as the mid-point of the target price range. VL publishes forecasts for three horizons: current scal year (i.e., year 1), the following scal year (i.e., year 2), and long run (i.e., year 5). Since the internal yearby-year forecasts of valuation attributes for years 3 and 4 are not published in the Value Line Investment Survey, at the suggestion of VL analysts, we interpolate data for these two years based on implied straight-line growth from year 2 to year 5.15 The most recent stock price reported by VL is used as the dependent variable in our study.16 For both RIM and DCF, the researcher must confront the occasional existence of negative terminal values. Such values can arise if either forecasted premiums given terminal price forecasts or valuation attributes at the horizon are negative. We choose not to cap negative terminal values at zero because any negative attribute at the horizon is expected to be impounded in current market price.
Equity Valuation Employing Terminal Value Expressions 5. Empirical results
639
Descriptive statistics Table 1 reports the relative importance of the various components of DCF and RIM. Discounted terminal value (DTV) accounts for the majority of intrinsic value in all three versions of the DCF model (i.e., 95.38 percent, 91.81 percent, and 93.19 percent for DCF1, DCF0, and DCF2, respectively).17 The importance of DTV in the DCF models is consistent with prior literature. Copeland, Koller, and Murrin (1995), for instance, document that, for a sample of companies appraised by McKensey and Company, nonprice-based DTV amounts to 56 to 125 percent of intrinsic value. The remaining two components of DCF models tend to have opposite signs in our data. Current book value (i.e., FA t ) is, on average, negative, reecting current net debt; whereas the present value of pre-horizon free cash ows coming to treasury from operations (i.e., PV) is positive. Turning to the RIM models, DTV makes up of 52.23 percent, 20.77 percent, and 25.53 percent of intrinsic value for RIM1, RIM0, and RIM2, respectively. These percentages are considerably lower than the corresponding gures for DCF. Conversely, current book value (i.e., B t ) takes on a more signicant role in all three versions of RIM than DCF (e.g., 41.04 percent for RIM1 versus 25.71 percent for DCF1), conrming the ndings of prior research that more wealth is captured in valuation attributes to the horizon under RIM than under DCF. Within the family of RIM models, Bt is least important and DTV most important when the ideal terminal value is employed. For example, Bt (DTV) accounts for 41.04 percent (52.23 percent) of the intrinsic value under RIM1, compared with 68.06 percent (20.77 percent) and 63.97 percent (25.53 percent) under RIM0 and RIM2, respectively. However, even for RIM0 and RIM2, DTV represents more than 20 percent of the intrinsic value estimates, implying that post-horizon forecasts of abnormal earnings remain crucial to rm valuation under RIM even though, as pointed out by P&S 1998 and Francis et al. 2000, current book value brings future cash ows forward. Two sets of analyses are performed in this study, one based on prediction error dened as the difference between model intrinsic value estimate and current stock price, scaled by current stock price, and the other based on regression analysis. Panels A and B of Table 2 present the distribution of signed and absolute prediction errors, respectively, for the overall sample period. As is evident from the fourth column, the skewness measures are uniformly positive across all valuation models, implying that our data are positively skewed. For the purpose of testing the predictions of Hypotheses 1 and 2, we therefore focus on the median, as opposed to the mean, signed and absolute prediction errors, and use non-parametric Wilcoxon signed rank tests. Some unusually large prediction errors are evident at both ends of the distributions, especially in models for which nonprice-based terminal value expressions are employed. The prediction error analysis, in particular that involving Hypothesis 2, may be affected because outliers can come from different rms depending on whether price- or non price-based models are used.18 To assess potential probCAR Vol. 18 No. 4 (Winter 2001)
640
TABLE 1 Relative importance of components of valuation models* Mean opening FA or B (% of mean IV ) DCF1 DCF0 DCF2 RIM1 RIM0 RIM2 8.46 ( 25.71%) 8.46 ( 45.58%) 8.46 ( 37.90%) 13.53 (41.04%) 13.53 (68.06%) 13.53 (63.97%) Mean PV (% of mean IV ) 9.98 (30.33%) 9.98 (53.77%) 9.98 (44.71%) 2.22 (6.73%) 2.22 (11.17%) 2.22 (10.50%) Mean DTV (% of mean IV ) 31.39 (95.38%) 17.04 (91.81%) 20.80 (93.19%) 17.22 (52.23%) 4.13 (20.77%) 5.40 (25.53%) Mean IV # (% of mean IV ) 32.91 (100.00%) 18.56 (100.00%) 22.32 (100.00%) 32.97 (100.00%) 19.88 (100.00%) 21.15 (100.00%)
Notes:
*
See the appendix for a description of DCF1, DCF0, DCF2, RIM1, RIM0, and RIM2. FA is the net nancial assets per share (i.e., cash and marketable securities minus debt and preferred equity), and B is the book value of owners equity per share; PV is the present value of operating cash ows to common shareholders or abnormal earnings to the horizon, on a per-share basis, under the discounted cash ows (DCF) or residual income model (RIM), respectively. DTV is the discounted terminal value per share given by the last component under DCF1, DCF0, DCF2, RIM1, RIM0, and RIM2. IV is the intrinsic value estimates per share under DCF1, DCF0, DCF2, RIM1, RIM0, and RIM2.
lems associated with outliers, we conduct the prediction error analysis with and without winsorizing at the 1st and 99th percentile. The results are very similar qualitatively speaking. Thus, only one set of results based on data before applying the winsorization procedure will be reported in the paper. Prediction-error analyses Results from tests of Hypothesis 1 Panel A of Table 3 reports the median intrinsic value estimates, median signed prediction errors, and pair-wise comparisons of these gures for the price-based valuation models over the entire sample period (1992 96) and by year. At the overall level, the median intrinsic values of $29.181 and $29.104 for DCF1 and

TABLE 2 Distribution of prediction errors Panel A: Signed prediction errors (bias) Overall (199296)* Standard Mean (%) Median (%) deviation Price-based models DCF1 RIM1 8.42% 8.39% 4.82% 4.73% 41.34% 37.95% 30.50% 34.36% 0.261 0.269 0.336 0.275 0.427 0.306
641
Skewness 1.624 1.557 1.454 1.613 1.771 1.623
Kurtosis 8.199 8.094 6.512 9.370 7.389 8.105
Nonprice-based models DCF0 37.76% RIM0 34.18% DCF2 24.18% RIM2 30.26%
Panel B: Absolute prediction errors (accuracy) Overall (199296) Standard Mean (%) Median (%) deviation Skewness Price-based models DCF1 RIM1 19.11% 19.54% 13.71% 14.18% 42.81% 38.80% 35.48% 36.42% 0.197 0.204 0.250 0.207 0.288 0.217 3.203 3.209 0.757 0.873 2.034 1.156
Kurtosis 21.069 20.109 3.151 7.409 11.180 8.541
Nonprice-based models DCF0 43.90% RIM0 38.73% DCF2 39.68% RIM2 37.19% Notes:
*
M P )/P . Signed prediction errors are calculated as ( IV it it it M P | /P , where P is the Absolute prediction errors are calculated as | IV it it it it M is the recent stock price published in the VL forecast report; and IV it intrinsic value estimate per share for security i in year t calculated under M = DCF1, DCF0, DCF2, RIM1, RIM0, and RIM2, described in the appendix.
RIM1, respectively, overestimate current median stock price of $28, reecting optimism in VL forecasts noted by Botosan 1997. For both models, the median signed prediction errors decline steadily over time. For example, the median signed prediction errors for DCF1 reduce to 1.43 percent and 1.95 percent in 1995 and 1996, respectively, from the peak of 11.95 percent in 1992. Thus, VL optimism appears to have completely abated toward the end of our sample period. These patterns are depicted in Figure 1. For the pooled 199296 data, the median intrinsic value estimates and median signed prediction errors for DCF1 and RIM1 are all within a very small neighborhood of one another (i.e., $29.181 versus $29.104; 4.82 percent versus 4.73 percent).
642
TABLE 3 Tests of hypothesis 1*: Median signed and absolute prediction errors for the price-based valuation models
Panel A: Median signed prediction errors (bias) Overall and by year 199296 1992 1993 1994 Median, Median, $ % 28 29.274 28.994 5.19 4.60 0.07 0.23 1.43 2.89 29.5 30.112 30.330 Median, Median, $ % 1995 1996 Median, Median, $ % 26 27.574 27.443 5.86 5.84 0.07
Median, Median, $ % 11.95 11.72 0.04
Median, Median, $ %
Median, Median, $ % 32 31.513 31.479 1.95 1.41 0.27
CAR Vol. 18 No. 4 (Winter 2001) 1994 Median, Median, $ % 29.274 28.994 12.49 13.08 0.00 1995 Median, Median, $ % 30.112 30.330 13.56 14.04 0.09 1996 Median, Median, $ % 31.513 31.479 13.82 13.42 0.00 (The table is continued on the next page.) Median, Median, $ % 27.574 27.443 0.15 14.24 14.82 14.77 15.56 0.08
Current stock price 28 DCF1 29.181 RIM1 29.104 Test of Hypothesis 1 DCF1 RIM1
4.82 4.73
26 27.873 28.126
0.14
Panel B: Median absolute prediction errors (accuracy) Overall and by year 199296 1992 1993
Median, Median, $ %
Median, Median, $ %
DCF1 29.181 RIM1 29.104 Test of Hypothesis 1 DCF1 RIM1
13.71 14.18
27.873 28.126
0.06

TABLE 3 (Continued) Notes:
*
643
Hypothesis 1 states that there is no difference in prediction errors across DCF1 and RIM1. Wilcoxon signed rank tests are employed to test the difference in median signed/absolute prediction errors.
M P )/P and absolute prediction Signed prediction errors are calculated as ( IV it it it M errors are calculated as | IV it Pit | /Pit , where Pit is the recent stock price M is the intrinsic value estimate per published in the VL forecast report; and IV it share for security i in year t calculated under M = DCF1, DCF0, DCF2, RIM1, RIM0, and RIM2, described in the appendix.
Signicant at the 1 percent level. Signicant at the 5 percent level.
Nevertheless, the Wilcoxon signed rank test performed on percentage errors rejects the prediction of Hypothesis 1 at the 1 percent level. The sensitivity of small median difference to statistical test may be partially explained by the power of test given the large number of observations overall, and by the fact that most (80 percent) of the differences are in the same direction. The support for Hypothesis 1 is considerably stronger when a separate analysis is performed for each of the sample years. In particular, none of the pair-wise comparisons in years 1992 to 1994 rejects the null of no difference (i.e., Hypothesis 1) at the conventional levels of signicance. The median absolute prediction errors and pair-wise comparisons based on these errors are presented in panel B of Table 3. For both DCF1 and RIM1, the annual median absolute prediction errors decline from their highest levels in 1992 to the lowest levels by the mid-point of our sample period (i.e., 1994). The trend reverses itself in the second half of the sample period. The prediction of Hypothesis 1 is not rejected in the last three years of the sample period (1994 96), but rejected in the rst two years (199293). Overall, the median absolute prediction errors are 13.71 percent and 14.18 percent for DCF1 and RIM1, respectively. The Wilcoxon signed rank test rejects Hypothesis 1 at the 1 percent level. In short, the evidence presented is largely consistent with the prediction that there is no difference in the median signed or absolute prediction errors across DCF and RIM models (Hypothesis 1), especially when analysis is conducted at the year-by-year level. In testing Hypothesis 1, the researcher is confronted with several potential sources of inconsistency that can lead to differences across valuation models. We now discuss three sources that we avoid. First, we employ Penmans version of DCF model (i.e., (4)) to avoid L&Os inconsistent discount rate error referred to in the introduction. Thus, even if the equity cost of capital were incorrectly measured, both DCF1 and RIM1 would produce the same incorrect intrinsic value so as not to affect the test of Hypothesis 1. Second, our conversations with VL personnel indicate that, in the Value Line Investment Survey, forecasts of free cash
644
Figure 1 Median signed prediction errors for price-based DCF and RIM: Years 1992 to 1996*
0.14 0.12
Median signed prediction error
0.10 0.08 0.06 0.04 0.02 0.00 0.02

1992 1993 1994 Year 1995 1996 DCF1 RIM1
M P )/P , where P is the recent Signed prediction errors are calculated as ( IV it it it it M is the intrinsic value stock price published in the VL forecast report; and IV it estimate per share for rm i in year t calculated under M = DCF1 and RIM1, described in the appendix. The graph depicts the median of signed prediction errors for all sample rms in each of the ve years under investigation (199296).
ows typically increase working capital unless the VL analyst anticipates some other uses for the cash, such as share repurchases or retirement of long-term debt. Value Line ensures internally in their spreadsheets that all projected sources and uses of cash are reconciled through a projected statement of funds, and that CSR holds for FA. Since it is not easy for the researcher to observe where VL has applied funds for a particular rm-year, we create our own FA continuity schedule, starting with opening net FA and building up the next period FA using VLs forecasts of Ct + , It + , it + , and dt + in (3). Effectively, we generate our own forecasts of future FA and do not use VLs forecasted long-term debt. This procedure guarantees that CSR will hold for our version of forecasted FA, just as it does internally for VL based on our discussions with VL analysts. This adjustment minimizes L&Os so-called missing cash ows problem. Third, 301 to 770 rm-year observations had negative opening book value of owners equity, and hence larger abnormal earnings than reported earnings under RIM1 during the forecast periods t + 1 to
645
t + 5. However, capping abnormal earnings at forecasted earnings for these rms would introduce inconsistencies in comparisons with DCF. For that reason, we do not impose an upper cap on abnormal earnings. Results reported in this and the next sections are nonetheless essentially the same qualitatively, with or without the capping requirement. For the same reason, we also do not impose a lower bound on the two rm-year observations where RIM1 intrinsic value is negative. Once again, our results are not sensitive to this treatment. We next turn to two sources of inconsistency that we do not avoid. First, for the DCF model, it is not practical for the researcher to adjust forecasted free cash ows for sources or uses of cash due to working capital requirements and deferred taxes. Regarding working capital, the cash versus non-cash components of forecasted working capital are not available from VL. For a typical rm in our sample, ignoring cash tied up in working capital overstates free cash ows, whereas not recognizing deferred taxes understates free cash ows. Second, for RIM, we do not force the CSR to hold when forecasted violations of CSR exist because violations of CSR do exist in U.S. accounting principles and, therefore, should exist in expectation.19 If one were to force CSR to hold, the plug would have to go to either forecasted earnings or forecasted equity infusions (i.e., negative dividends). The latter treatment implies that the corresponding DCF model valuation attributes would have to change, leading to an unknown degree of error in the DCF model. Since we do not adjust for these two sources of inconsistency, the empirical equivalence of DCF and RIM is not guaranteed to hold. Nevertheless, even without attempting adjustments in these areas, the differences in errors across valuation models, reported in Table 3, are small. Results from tests of Hypothesis 2 Panel A (B) of Table 4 presents results from testing the prediction of Hypothesis 2 that the median signed (absolute) prediction errors are smaller for the price-based valuation models than for the corresponding non price-based models. For the pooled 1992 96 data, the median signed prediction errors of 4.82 percent (4.73 percent) for DCF1 (RIM1) are considerably closer to zero than 41.34 percent ( 37.95 percent) and 30.50 percent ( 34.36 percent) for DCF0 (RIM0) and DCF2 (RIM2), respectively (see panel A).20 Wilcoxon signed rank tests of pair-wise differences between the price-based and the non price-based models within the same family are all signicant at the 1 percent level, supporting the prediction of Hypothesis 2 at the overall level. Results are similar and uniformly in support of Hypothesis 2 when analysis is extended to each sample year. For example, focusing on the last two years when VL optimism is minimal and for which use of price-based models as a benchmark is most appropriate, the median signed prediction errors of 2.89 percent and 1.41 percent for RIM1 are smaller than 40.06 percent and 43.32 percent ( 36.27 percent and 39.98 percent) for RIM 0 (RIM 2), respectively, again signicant at the 1 percent level. Over the same two years, DCF1 is also associated with considerably smaller median signed prediction errors than DCF0 and DCF2 (1.43 percent versus 42.48 percent and 31.07 percent in 1995; 1.95 percent versus 47.81 percent and 37.86 percent in 1996).
646
TABLE 4 Tests of Hypothesis 2*: Median signed and absolute prediction errors for the price-based and non price-based valuation models
Panel A: Median signed prediction errors (bias) Overall and by year 1992 96 1992 1993 1994 Median, Median, $ % 28 29.274 15.552 18.382 5.19 42.77 32.62 1.43 42.48 31.07 29 30.112 16.103 19.283 Median, Median, $ % 1995 1996 Median, Median, $ % 26 27.574 14.303 16.683 5.86 40.25 30.74
CAR Vol. 18 No. 4 (Winter 2001) Median, Median, $ % 32 31.513 17.084 20.348 1.95 47.81 37.86 11.95 33.84 18.44 43.24 29.19 13.92 11.72 27.17 21.70 27.443 15.212 15.775 43.42 40.79 3.07 28.994 16.647 17.460 38.42 32.67 5.23 42.21 39.04 2.91 45.68 34.50 10.28 5.84 37.52 34.58 44.59 35.28 10.06 4.60 39.04 35.80 30.330 17.238 18.189 42.42 31.71 10.25 2.89 40.06 36.27 39.53 36.89 3.11 31.479 18.347 19.636 42.55 33.32 9.52 1.41 43.32 39.98 40.72 37.23 3.26 (The table is continued on the next page.)
Median, Median, $ %
Median, Median, $ %
4.82 41.34 30.50
26 27.873 16.478 19.880
Current stock price 28 DCF1 29.181 DCF0 15.768 DCF2 19.062 Tests of Hypothesis 2 DCF1-DCF0 DCF1-DCF2 DCF0-DCF2 RIM1 29.104 RIM0 17.042 RIM2 17.918 Tests of Hypothesis 2 RIM1-RIM0 RIM1-RIM2 RIM0-RIM2
44.00 33.17 10.67 4.73 37.95 34.36
28.126 17.998 19.170
40.84 37.38 3.37
TABLE 4 (Continued)
Panel B: Median absolute prediction errors (accuracy) Overall and by year 1992 96 1992 1993 1994 Median, Median, $ % 28 29.274 15.552 18.382 12.49 43.60 35.38 13.56 42.87 35.61 29 30.112 16.103 19.283 Median, Median, $ % 1995 1996 Median, Median, $ % 26 27.574 14.303 16.683 14.24 41.19 34.29
Median, Median, $ % 14.77 36.87 30.15
Median, Median, $ %
Median, Median, $ % 32 31.513 17.084 20.348 13.82 48.64 40.02
13.71 42.81 35.48
26 27.873 16.478 19.880
Current stock price 28 DCF1 29.181 DCF0 15.768 DCF2 19.062 Tests of Hypothesis 2 DCF1-DCF0 DCF1-DCF2 DCF0-DCF2 RIM1 29.104 RIM0 17.042 RIM2 17.918 Tests of Hypothesis 2 RIM1-RIM0 RIM1-RIM2 RIM0-RIM2 21.25 13.97 7.83 15.56 29.88 29.11 27.443 15.212 15.775 25.97 21.67 2.39 28.994 16.647 17.460 13.09 10.90 3.22 27.18 24.12 2.36 26.41 17.66 7.93 14.82 38.24 36.25 30.75 22.41 7.98 13.08 39.24 37.10 30.330 17.238 18.189 28.21 21.04 7.67 14.04 40.72 38.63 26.58 25.32 2.47
28.11 20.32 7.96 14.18 38.80 36.42
28.126 17.998 19.170
31.479 18.347 19.636
33.20 24.91 8.15 13.42 43.39 40.11 29.91 26.79 2.76 (The table is continued on the next page.)
25.55 22.62 2.61
647
648

*
Hypothesis 2 states that the terminal value expression that employs VLs forecasted price will have the lowest prediction errors within each class of the DCF and RIM models. Wilcoxon signed rank tests are employed to test the difference in median signed/absolute prediction errors.
M P )/P and absolute prediction Signed prediction errors are calculated as ( IV it it it M errors are calculated as | IV it Pit | /Pit , where Pit is the recent stock price M is the intrinsic value estimate per published in the VL forecast report; and IV it share for security i in year t calculated under M = DCF1, DCF0, DCF2, RIM1, RIM0, and RIM2, described in the appendix.
Signicant at the 1 percent level.
Turning to accuracy, for the entire sample period, the median absolute prediction errors for DCF1 and RIM1 are signicantly lower than those for the corresponding non price-based models. The contrast for DCF is 13.71 percent versus 42.81 percent and 35.48 percent, and that for RIM is 14.18 percent versus 38.80 percent and 36.42 percent (see panel B), lending strong support for Hypothesis 2. The results are equally strong at the year-by-year level. Evidence on the relative performance of RIM versus DCF with ad hoc growth assumptions in the terminal value expression is mixed. At an assumed growth rate of 0 percent, RIM is less biased and more accurate than DCF overall (i.e., 37.95 percent versus 41.34 percent; 38.80 percent versus 42.81 percent); whereas the converse is true when the growth rate is assumed to be 2 percent (i.e., 34.36 percent versus 30.50 percent; 36.42 percent versus 35.48 percent). Similar patterns can also be found in each of the ve sample years. These results are to be contrasted with analogous pair-wise comparisons between RIM and DCF when the ideal terminal price forecasts are employed. As reported under the heading Results from tests of Hypothesis 1, above, RIM1 does not dominate, nor is it dominated by DCF1 for most of the annual comparisons of median signed and absolute prediction errors. Thus, the conclusion by P&S 1998 and Francis et al. 2000 that RIM outperforms DCF would appear to be quite sensitive to the growth assumption made about valuation attributes and the way terminal values are measured. As sensitivity tests of Hypothesis 2, we repeat the analysis under the alternative, albeit similarly ad hoc, growth assumptions of 4 percent, 6 percent, 8 percent, and 10 percent for DCF employed in Francis et al. 2000. The results indicate that the median absolute prediction errors for DCF1 continue to be lower than the corresponding ad hoc growth models. The median differences are 17.41 percent, 24.20 percent, 58.98 percent, and 154.40 percent, respectively, all signicant at the 1 percent level. For RIM, we use Gebhardt, Lee, and Swaminathams 2001 fade-rate procedure to generate the alternative ad hoc growth assumption. For each sample rm-year observation, the linear fade rate is dened as the rate at which a rms abnormal return on equity at the horizon will converge to the industry average evenly
649
over a seven-year period beyond the forecast horizon. The median difference in absolute prediction errors between RIM1 and the fade-rate-based RIM model (denoted RIMf) is 35.82 percent, in favor of RIM1. The corresponding median signed difference (i.e., RIM1 RIMf) is 52.07 percent, implying that RIMf seriously understates the post-horizon goodwill projected by VL. Taken together, these results are strongly in support of the prediction of Hypothesis 2, and suggest that the researcher should exercise care in interpreting results based on models that employ ad hoc terminal value expressions, because intrinsic value estimates in these models can be severely downward biased. This observation applies to studies such as Frankel and Lee 1998, who use a simple perpetuity expression for their RIM terminal values to identify mispriced securities and protable trading strategies; and Gebhardt et al. 2001, who use a simple faderate procedure for their RIM terminal values in order to solve for a rms ex ante cost of capital implied by the RIM intrinsic value estimates and current stock price. As with tests of Hypothesis 1, the researcher needs to deal with several potential sources of inconsistency in testing Hypothesis 2. First, we adopt the approach recommended by L&O 2001 to extrapolate valuation attributes in the rst year beyond the forecast horizon (see section 3, above). However, we also repeat the analysis using the approach commonly employed in the horse race literature by redening year t + 6 abnormal earnings as year t + 5 abnormal earnings multiplied by (1 + g) (see P&S 1998 and Francis et al. 2000). The results (not reported in a table) are qualitatively the same across these two extrapolation methods. For example, focusing on accuracy, the median absolute prediction errors for RIM2 and DCF2 now become 37.25 percent and 37.42 percent, compared with the corresponding gures of 36.42 percent and 35.48 percent reported previously in panel B of Table 4. The prediction of Hypothesis 2 is once again strongly supported at the 1 percent level, implying that our earlier conclusion about the superiority of models using VL terminal price forecasts over non price-based models within the same family are robust to the manner in which ad hoc growth rates are applied to the terminal value expressions. Second, 8 (49) rm-year observations have negative intrinsic values under RIM0 (DCF0) and 9 (34) under RIM2 (DCF2). For these rms, unless negative intrinsic values are capped at zero, comparing across the pricebased and non price-based models would overstate the difference due to limited liability constraints. Notwithstanding this capping requirement, it should be noted that all the results continue to hold when the restriction is relaxed. Third, rms might have reached a steady state prior to the horizon potentially affecting tests of Hypothesis 2. To rule out this possibility, we delete 202 observations whose abnormal earnings change signs from positive to negative before the horizon and repeat the analysis presented in Table 4. The results (not reported in a table) are similar qualitatively. For example, differences in the median absolute prediction errors are 27.09 percent, 18.93 percent, 24.65 percent, and 21.90 percent for DCF1 DCF0, DCF1 DCF2, RIM1 RIM0, and RIM1 RIM2, respectively. Wilcoxon signed rank tests again all support Hypothesis 2 at the 1 percent level.
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Regression analyses Panels A and B of Table 5 report results from the pooled GLS panel regressions of contemporaneous stock prices on intrinsic value estimates for DCF and RIM models, respectively. For this analysis and that reported in Table 6, we use the GLS procedure because standard tests reject homoscedasticity of model residuals obtained from OLS regressions using share-deated variables.21 The GLS procedure transforms the data to correct for heteroscedasticity and removes autocorrelation from the residuals (Kmenta 1986). While GLS does not correct for cross-sectional correlation in residuals, any such correlation is unlikely to represent a serious departure from standard assumptions, given modest calendar and industry clustering in our sample. Several results from Table 5 conrm the impressions obtained previously. First, as a benchmark model, the results for DCF1 are striking. While the slope coefcient of 0.966 differs signicantly from a theoretical prediction of unity at the 1 percent level, the R2 of 93.71 percent suggests that the measurement error resulting from using VL terminal price forecasts as a proxy for market expectations is modest. Second, the R2s of 93.71 percent and 93.04 percent for the DCF1 and RIM1 models are quite close, implying that these models apparently have similar ability to explain cross-sectional variation in current stock price. To test for the pair-wise difference in R2s, we compute the Vuong Z-statistic (Dechow 1994) for DCF1 versus RIM1 and cannot reject the null of no difference at the 5 percent level.22 This result lends further support for the prediction of Hypothesis 1 that, with ideal terminal value expressions, the choice of valuation models is a matter of indifference. Third, the R2s are considerably higher for the price-based models, compared with their non price-based counterparts. For the DCF models, the former is 93.71 percent, and the latter are 67.95 percent and 60.46 percent for DCF0 and DCF2, respectively. The corresponding gures for RIM are 93.04 percent versus 79.65 percent and 77.02 percent, respectively. Thus, both price-based valuation models appear to be far more successful in explaining the variability of current stock price than the non price-based models within the same family, a result consistent with the prediction of Hypothesis 2. Fourth, the R2s for the non price-based RIM models are considerably higher than those for the non price-based DCF models (i.e., 79.65 percent versus 67.95 percent and 77.02 percent versus 60.46 percent, based on the 0 percent and 2 percent growth assumptions, respectively), implying that RIM is superior to DCF in situations where terminal price forecasts are not available. Panels A and B of Table 6 present evidence on the incremental explanatory power of various components of intrinsic value estimates for the DCF and RIM models, respectively. Comparing across variants within the same family of DCF and RIM valuation models, we nd that the overall R2 is at its highest level in DCF1 and RIM1 (i.e., 93.40 percent versus 67.68 percent and 63.66 percent for DCF; 92.79 percent versus 81.11 percent and 80.52 percent for RIM), establishing once again the superiority of price-based models over their non price-based counterparts (i.e., Hypothesis 2).
TABLE 5 Pooled GLS panel regression of contemporaneous stock prices on intrinsic value estimates*
Panel A Non price-based DTV, g = 0% Coefcient DCF0 6.245 15.604 0.899 67.95 % 7.485 16.161 0.706 60.46 % 52.272 66.692 DCF2 50.076 56.638 23.643 t -statistics H0: aj = 0 Coefcient t -statistics H0: aj = 1 t -statistics H0: aj = 0 Non price-based DTV, g = 2% t -statistics H0: aj = 1
Price-based DTV
Coefcient
t -statistics H0: aj = 0
DCF1
Intercept IV R2
0.162 0.966 93.71 %
1.101 176.740
Panel B Non price-based DTV, g = 0% Coefcient RIM0 8.741 9.943 1.107 79.65 % 34.796 90.630 8.753 11.341 0.971 77.02 % t -statistics H0: aj = 0 t -statistics H0: aj = 1 Non price-based DTV, g = 2% Coefcient t -statistics H0: aj = 0 RIM2 38.305 83.851 2.478 t -statistics H0: aj = 1
Price-based DTV
Coefcient
RIM1
Intercept IV R2
0.598 0.950 93.04 %
3.886 167.520
Notes:
M + e . The slope coefcient on each of the intrinsic value estimates is predicted to be 1, where IV M is the intrinsic Model: Pit = a0 + a1 IV it it it value estimate per share for rm i in year t calculated under M = DCF1, DCF0, DCF2, RIM1, RIM0, and RIM2, described in the appendix.
DTV is the discounted terminal value per share given by the last component of valuation models described above.
Signicant at the 1 percent level.
651
652
TABLE 6 Pooled GLS panel regression of contemporaneous stock prices on the components of intrinsic value estimates*
Panel A Non price-based DTV, g = 0% t -stat. t -stat. H0: H0: Incremental Coefcient j = 0 j = 1 R2 Non price-based DTV, g = 2% t -stat. t -stat. H0: H0: Incremental Coefcient j = 0 j = 1 R2
CAR Vol. 18 No. 4 (Winter 2001) 15.443 0.902 1.128 0.760 67.68% 17.13% 15.49% 20.09% DCF0 49.050 52.254 5.683 29.016 3.290 27.719 9.401 16.126 0.806 1.146 0.530 63.66% DCF2 51.914 40.478 9.767 12.76% 26.114 3.325 12.50% 24.023 21.277 16.07% Non price-based DTV, g = 0% t -stat. t -stat. H0: H0: Incremental Coefcient j = 0 j = 1 R2 Non price-based DTV, g = 2% t -stat. t -stat. H0: H0: Incremental Coefcient j = 0 j = 1 R2 8.625 1.249 1.679 0.630 81.11% RIM0 30.749 64.622 12.867 28.865 11.675 19.143 11.257 31.65% 3.61% 3.70% 8.990 1.222 1.765 0.457 80.52% RIM2 30.976 62.331 11.328 31.62% 30.190 13.084 4.29% 17.604 20.918 3.11% (The table is continued on the next page.)
Price-based DTV t -stat. t -stat. H0: H0: Incremental Coefcient j = 0 j = 1 R2
Intercept FA PV DTV R2
DCF1 0.038 0.257 0.951 86.977 4.476 2.396 1.043 58.253 0.942 133.250 8.215 93.40%
15.61% 7.82% 45.81%
Panel B
Price-based DTV t -stat. t -stat. H0: H0: Incremental Coefcient j = 0 j = 1 R2
Intercept B PV DTV R2
0.521 0.962 0.909 0.945 92.79%
RIM1 3.143 73.233 2.863 25.812 2.592 82.589 4.780
9.66% 0.73% 15.38%

*
653
Model for DCF is Pit = 0 + 1FAit + 2 PVit + 3 DTVit + it and model for RIM is Pit = 0 + 1Bit + 2 PVit + 3 DTVit + it , where Pit is the recent stock price published in the VL forecast report; FA is the net nancial assets per share (i.e., cash and marketable securities minus debt and preferred equity); B is the book value of owners equity per share; PV is the present value of operating cash ows to common shareholders or abnormal earnings to the horizon, on a per-share basis, under the discounted cash ows (DCF) or residual income model (RIM), respectively; and DTV is the discounted terminal value per share given by the last component under DCF1, DCF0, DCF2, RIM1, RIM0, and RIM2. Incremental R2 is calculated as the difference between R2 for the full model and R2 for the model excluding the variable in question. Signicant at the 1 percent level. Signicant at the 5 percent level.
At the component level, the incremental explanatory power of DTV is highest when VL price forecasts are used in the terminal value calculations. For instance, DTV explains 45.81 percent (15.38 percent) of the cross-sectional variations in contemporaneous stock prices in DCF1 (RIM1), but only 20.09 percent (3.70 percent) and 16.07 percent (3.11 percent) for DCF0 (RIM0) and DCF2 (RIM2), respectively. These results imply that VL forecasts of (P FA ) or (P B ) are far less noisy than the non price-based DTVs in capturing post-horizon goodwill, conrming the impression from Table 1 that DTV accounts for the lions share of intrinsic value estimates in the price-based valuation models. In both DCF and RIM, the coefcients on DTV are much closer to the theoretical prediction of unity in the price-based models than in the non price-based models (i.e., 0.942 versus 0.760 and 0.530 for DCF; 0.945 versus 0.630 and 0.457 for RIM). However, the theoretical prediction of unity is rejected for all the slope coefcients at the 1 percent level. When the comparisons are made across families of valuation models, the overall R2s appear to be similar when VL terminal price forecasts are employed (i.e., 93.40 percent and 92.79 percent for DCF1 and RIM1, respectively). A Vuong test fails to reject the null of no difference in R2 between DCF1 and RIM1 at the conventional levels of signicance. This result is consistent with the prediction of Hypothesis 1. Similar to the evidence presented in Table 5, the non price-based RIM models continue to have higher overall R2 than the corresponding DCF, regardless of the growth assumption (i.e., 81.11 percent versus 67.68 percent given 0 percent growth; 80.52 percent versus 63.66 percent given 2 percent growth).
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Sensitivity analyses Analysis based on VLs uncertainty about future stock prices As discussed in section 4, the target price range at the forecast horizon reects VLs uncertainty about future stock prices. In particular, uncertainty is directly related to the width of the range. A priori, one would expect to see larger prediction errors and a diminished edge of the price-based valuation models over those that employ non price-based terminal value expressions, when VL is less certain about the future. To gain some insight into this issue and provide indirect evidence that VL target price forecasts are judgemental in nature, we rank our sample observations pooled over the 1992 96 period in ascending order according to the degree of uncertainty facing VL, where uncertainty is measured as the difference between the two endpoints of the range, scaled by the mid-point. Focusing on accuracy, we rst compute the median absolute prediction errors for the top (i.e., most certain) and bottom (i.e., least certain) quartiles. The gures for DCF1 and RIM1 are 12.40 percent versus 16.22 percent and 12.43 percent versus 16.64 percent, respectively. Wilcoxon two-sample tests of pair-wise comparisons across the top and bottom quartiles for each of the two price-based models are all signicant at the 1 percent level, implying that VL target price forecasts are less representative of the investor beliefs impounded in the current market price as uncertainty increases. Next, we compute the difference in the median absolute prediction errors between DCF1 and DCF0, and RIM1 and RIM0 within the same quartile. The differences for the top and bottom quartiles are 29.14 percent and 22.99 percent ( 27.18 percent and 18.23 percent) for DCF1 DCF0 (RIM1 RIM0), respectively. A negative difference reects greater representativeness of the pricebased valuation model, compared with the corresponding ad hoc 0 percent growth model. We then contrast the pair-wise differences for the same family across the top and bottom quartiles using a Wilcoxon two-sample test, and nd it to be significant for both DCF and RIM models at the 1 percent level. The result is similar for interquartile comparison of RIM1 RIM2, whereas an analogous comparison of DCF1 DCF2 is not statistically signicant at any conventional level. These results once again suggest a generally declining representativeness edge of pricebased valuation models over their non price-based counterparts when VL faces greater uncertainty about the future, conrming our earlier understanding based on conversations with VL analysts that VL price forecasts are judgemental, rather than mechanical, in nature. Analysis based on Fama-French industry cost of equity Following the convention in the literature, we have addressed the issue of risk by discounting a stream of future ows of valuation attributes (i.e., cash ows and abnormal earnings) at a risk-adjusted discount rate. As discussed in section 4, each rms risk premium is calculated as the product of VL rm-specic beta and an assumed market premium. Feltham and Ohlson (1999) point out that this approach is ad hoc and lacks theoretical foundation. The conceptually preferred method
655
would involve adjusting valuation attributes for risk and then discounting the resulting expressions at a riskless rate. However, implementing the certainty equivalence approach advocated by Feltham and Ohlson is difcult in practice. As an alternative, we reperform the analysis using Fama and Frenchs 1997 industry costs of equity. This requires that we rst classify our sample rms into one of the 48 industries described in Appendix A of Fama and French (179 81), and then use industry risk premiums from the ve-year rolling three-factor model (see last column, Table 7 of Fama and French, 172 3). The results (not reported in a table) are very similar to those reported previously in Tables 3 6, and provide comfort that the ndings of this study are unlikely to be driven by the way we capture risk. 6. Conclusion Prior studies by Penman and Sougiannis 1998 and Francis et al. 2000 have compared the bias and accuracy of the non price-based DCF and RIM models, measured in terms of the signed and absolute prediction errors, respectively, and concluded that RIM outperforms DCF. In this study, we provide evidence to show that these ndings need not hold when Penmans 1997 theoretically ideal terminal value for each model is employed. Using Value Line terminal stock price forecasts at the horizon to proxy for such values, we explore the empirical equivalence of DCF and RIM over a ve-year valuation horizon under the assumptions that any measurement error in VL price forecasts is neutral across these valuation models, and that we have avoided the errors that can impede a comparison of such models. For the overall sample, the median absolute prediction errors are 13.71 percent and 14.18 percent for DCF1 and RIM1, respectively. Thus, focusing on accuracy, RIM does not dominate DCF when the ideal terminal values are employed. Contrasting intrinsic values for models employing terminal price forecasts with those that do not, we nd that, for both DCF and RIM, the price-based valuation models outperform the corresponding non price-based models by a wide margin. Of course, using VL price forecasts as the appropriate benchmark is invalid if such forecasts are optimistic. However, even for the last two years of our sample (1995 96) when the optimism in VL price forecasts has abated to a negligible level, our median signed prediction error evidence continues to indicate a serious downward bias when ad hoc terminal value expressions are used. These results imply that researchers who study the ex ante cost of capital or trading strategies using ad hoc terminal value expressions for RIM should exercise care in interpreting their results. Replacing VL terminal price forecasts with conventional terminal value expressions using ad hoc growth estimates, similar to those employed by P&S 1998 and Francis et al. 2000, we are able to replicate their ndings that RIM outperforms DCF. For example, when regressing current stock prices on intrinsic values, the R2 is highest in RIM, compared with DCF (e.g., 79.65 percent versus 67.95 percent, and 77.02 percent versus 60.46 percent under 0 percent and 2 percent growth assumptions, respectively). The superiority of RIM over DCF when the ideal terminal value is not available is explained by P&S 1998 as follows: current book values of owners equity bring future cash ows forward and leave relaCAR Vol. 18 No. 4 (Winter 2001)
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tively little value to be captured in the conventional terminal value expressions; whereas the DCF model expenses operating assets and defers most of the value to be captured at the horizon. For example, under a 0 percent (2 percent) growth assumption, 20.77 percent (25.53 percent) of intrinsic value for RIM is derived from discounted terminal value, and the corresponding gure for DCF is 91.81 percent (93.19 percent). Any horse race between RIM and DCF may be biased against DCF because of the inherent limitations in estimating the Copeland et al. 1995 version of the nance free cash ow model, an approach employed by Francis et al. 2000 using VL data. To address this issue, we estimate a version of DCF introduced by Penman 1997. This alternative specication is better suited to VLs data because the valuation attribute, free cash ows to common, is available from VL and there is no need to estimate the WACC. Nevertheless, we caution that implementing Penmans version of DCF empirically using VL data may still contain measurement errors because VL does not provide forecasts of either deferred income taxes or cash tied up in working capital. Given these practical limitations of estimating DCF, it is quite remarkable that we were able to establish the approximate equivalence between DCF1 and RIM1. For students of nancial statement analysis, our paper contains several important messages. We agree with P&S 1998 and Francis et al. 2000 that RIM outperforms DCF when ideal terminal values are not available. However, we also show that these models are empirically equivalent given ideal terminal values. Thus, in our view, the main focus of valuation analysis should be improving forecasts of attributes beyond a nite horizon. Post-horizon forecasts of free cash ows or abnormal earnings can easily articulate across valuation approaches and ultimately articulate back to the benchmark model of forecasting the present value of expected dividends. A reliable set of post-horizon forecasts of valuation attributes for DCF and RIM gives the analyst the key to valuation, namely, a reliable price forecast at the horizon. Hence, the dilemma over which valuation model to use is replaced by the challenge of forecasting post-horizon valuation attributes. This study has focused on the pricing errors and viewed market efciency as a maintained assumption. As an avenue for future research, tests for equivalence could be conducted with future excess returns. Under the null of equivalence, valuation models using ideal terminal value expressions should generate mispricing signals (i.e., intrinsic value minus price) that yield identical excess returns when trading strategies are implemented.
Equity Valuation Employing Terminal Value Expressions Appendix Summary of valuation models and notations Valuation models
DCF1: Wt (DCF1) = FA t +
T
657
=1
R
T
E t [C t + I t + + i t + (R 1) FA t + 1] + R T E t (Pt + T FA t + T)
=1
R R
T
E t [C t + I t + + i t + (R 1) FA t + 1]
+ RT(R 1) 1 E t [C t + T + 1 I t + T + 1 + i t + T + 1 (R 1) FA t + T]
E t [C t + I t + + i t + (R 1) FA t + 1]
=1
+ RT(R 1 g) 1 E t [C t + T + 1 I t + T + 1 + i t + T + 1 (R 1) FA t + T]
RIM1: Wt (RIM1) = Bt +
=1
T
E t ( X t + ) + R T E t (Pt + T Bt + T )
RIM0: Wt (RIM0) = Bt +
=1
T
R R
E t ( X t + ) + R T(R 1)1 E t ( X t + T + 1)
RIM2: Wt (RIM 2) = Bt +
E t ( X t + ) + R T(R 1 g)1 E t ( X t + T + 1)
=1
Notations
Wt R = = = = = Intrinsic value estimates per share under DCF1, DCF0, DCF2, RIM1, RIM0, and RIM2. One plus the cost of equity. VLs forecasted price at the horizon, t + T. Operating cash ows, on a per-share basis, for forecast year t + . Capital expenditures, on a per-share basis, for forecast year t + . Interest ow from net nancial assets for forecast year t + , on a per-share basis. It represents interest paid (earned), including preferred dividends, if net nancial assets are negative (positive). CAR Vol. 18 No. 4 (Winter 2001)
Pt + T = Ct + It + it +
658
Xt + = FAt Bt = =
a

Abnormal income, on a per-share basis. Net nancial assets per share (i.e., cash and marketable securities minus debt and preferred equity). Book value of owners equity per share.
In addition, the numerator of the terminal value expression for the DCF0/ DCF2 and RIM0/RIM2 models is given by: Ct + T + 1 It + T + 1 + it + T + 1 (R 1)FA t + T = (1 + g)(C t + T I t + T + i t + T) (R 1)FA t + T , and X t + T + 1 = (1 + g) X t + T (R 1)Bt + T , respectively. Endnotes
1. The substitution works because both DCF and RIM are accounting systems (cash versus accrual accounting) that obey a clean surplus relation. However, the substitution can just as easily occur in the opposite direction such that one ends up back with PVED. The choice between these three models, for innite valuation horizons, is a matter of indifference. 2. Some caveats are in order. First, as discussed in section 3, VL forecasts cash ows to common, not operating, cash ows. Second, VLs denition of cash ows ignores deferred income taxes and changes in working capital. These limitations could bias model comparisons against the DCF model. 3. The 0.67 estimate pertains to the sum of present value of forecasted (P B ) and forecasted abnormal earnings for the last three years of the VL forecast horizon. When the second component is separated, the (unreported) valuation coefcient on terminal forecasts of (P B ), according to Abarbanell and Bernard 2000, is only slightly higher. 4. The version of our RIM models that is closest to Sougiannis and Yaekura 2001 is RIM2, which assumes a 2 percent growth rate. As reported in section 5, the median signed and absolute prediction errors for our RIM2 model are 34.36 percent and 36.42 percent, respectively, comparable to those documented by Sougiannis and Yaekura using I/B/E/S data. 5. See Proposition 1 of Feltham and Ohlson 1995 for a reconciliation of the RIM and DCF models when innite horizons and risk neutrality are assumed. 6. The correction is evident since i in (4) denotes the interest expense (income) that will be reported at date t + . 7. In both cases, the rm is assumed to have reached a steady state at the horizon. The 2 percent growth rate approximates the rate of ination during our sample period. CAR Vol. 18 No. 4 (Winter 2001)
a
659
8. Implicitly, we assume that the residual cash ows from nancial assets grow at the same rate as that generated by operating assets. If nancial assets were marked to market, expected nancial residual cash ows would be zero, and the terminal value would depend only on operating cash ows. 9. The results for the DDM model (not reported in a table) are in fact exactly the same as those under DCF1, which appear in Tables 3 6. See section 5 for an elaboration. 10. To see this, note that if VL simply employs the reciprocal of the equity cost of capital as a forecasted P/E ratio at the horizon, (7a) will collapse to (7b) because (Pt + 5 Bt + 5) = Xt + 6 /re Bt + 5 = (Xt + 6 re Bt + 5 )/re = X ta+ 6 / re, under the assumption that Pt + 5 = Xt + 6 /re. 11. Sectors affected include retail stores and airlines. 12. When the VL rm-specic beta is missing, the average VL industry beta at the twodigit SIC level is used. The historic market premium of 6 percent is appropriate, according to Ibbotson and Sinqueeld 1983. 13. For most of our sample rms, f s are given by (1/4), implying that the forecast is generally made in the third quarter. 14. Specically, the rst period abnormal earnings for RIM, covering a fraction of the year from forecast (i.e., evaluation) date to the end of forecast year, are X ta+ 1 = f X t + 1 [(1 + r) f 1]Btq , where Btq = Bt + (1 f )(Xt + 1 Dt + 1). For DCF, the rst f period residual nancial income is Y ta + 1 = f (Ct + 1 It + 1) [(1 + r) 1]FAtq, where FAtq = FAt + (1 f )(Ct + 1 It + 1 Dt + 1). The notation is as dened in the text and summarized in the appendix. 15. VL forecasts to be interpolated using this procedure include cash ows, capital spending, number of common shares outstanding, dividends, and tax rates. In order to preserve CSR in years 3 and 4, we assume that earnings for these two years are equal. Appealing to CSR for years 3 to 5 and solving for Xt + 3 (or equivalently Xt + 4 ), we get Xt + 3 = Xt + 4 = 1 2 (Bt + 5 Xt + 5 + dt + 5 Bt + 2 + dt + 3 + dt + 4 ). 16. We use the most recent VL stock price prior to the forecast date as the dependent variable because it represents the markets evaluation of the rm at the time when VL generates its forecasts. At that time, the conditioning information set of the market and that of VL are approximately synchronous in time. Allowing the passage of time so that market price impounds VL forecasts would introduce a price inuenced by subsequent information not available to VL at the forecast date and hence confound inferences. 17. These percentages are very similar to that for DDM (not reported in a table) where 92.28 percent of intrinsic value comes from DTV, implying that dividend payments to the horizon per se are only value relevant at the margin because they represent wealth distribution rather than wealth creation. 18. The impact on the test of Hypothesis 1 is minimal because there is substantial (i.e., 76 percent) overlap in the rms falling in the extreme distributions of DCF1 and RIM1 models. 19. Note that 258 (or 12.27 percent) of our 2,110 sample observations do not satisfy CSR for book values within 5 percent of book values. This is consistent with Bushee 2001, who reports that for his sample VLs expectational data satisfy a similar CSR condition about 90 percent of the time.
660
20. The corresponding median signed prediction errors in Francis et al. 2000 are 42.7 percent and 28.2 percent for DCF0 and RIM0, respectively. They do not report results for DCF2 and RIM2. 21. The results presented in both tables are based on a subset of the original sample, after deleting 35 observations (or seven rms) with studentized residuals exceeding an absolute value of 2.5. 22. As discussed earlier, the Kmenta 1986 GLS procedure is essentially OLS after transforming the data to remove autocorrelation and heteroscedasticity. Since the Vuong test is appropriate for OLS, it is also appropriate for residuals arising from the nal-stage regression.
References
Abarbanell, J. 1991. Do analysts earnings forecasts incorporate information in prior stock price changes? Journal of Accounting and Economics 14 (2): 147 65. Abarbanell, J., and V. Bernard. 1992. Tests of analysts overreaction/underreaction to earnings information as an explanation for abnormal stock price behavior. Journal of Finance 47 (3): 1181 208. . 2000. Is the US stock market myopic? Journal of Accounting Research 38 (2): 221 42. Bandyopadhyay, S., L. Brown, and G. Richardson. 1995. Analysts use of earnings forecasts in predicting stock returns: Forecast horizon effects. International Journal of Forecasting 11 (3): 429 45. Bernard, V. 1995. The Feltham-Ohlson framework: Implications of empiricists. Contemporary Accounting Research 12 (Spring): 733 47. Botosan, C. 1997. Disclosure level on the cost of equity capital. Accounting Review 72 (3): 323 50. Bushee, B. J. 2001. Do institutional investors prefer near-term earnings over long-run value? Contemporary Accounting Research 18 (2): 207 46. Copeland, T., T. Koller, and J. Murrin. 1995. Valuation: Measuring and managing the value of companies. 2nd ed. New York: John Wiley & Sons. Copeland, T., and D. Mayers. 1982. The Value Line enigma (1965-1978): A case study of performance evaluation issues. Journal of Financial Economics 10 (3): 289 322. Cornell, B. 1993. Corporate valuation: Tools for effective appraisal and decision making. Homewood, IL: Business One Irwin. DeBondt, W., and R. Thaler. 1990. Do security analysts overreact? American Economic Review 80 (2): 52 57. Dechow, P. M. 1994. Accounting earnings and cash ows as measures of rm performance: The role of accounting accruals. Journal of Accounting and Economics 18 (1): 3 42. Fama, E., and K. French. 1997. Industry cost of equity. Journal of Financial Economics 43 (2): 153 94. Feltham, G., and J. Ohlson. 1995. Valuation and clean surplus accounting of operation and nancial activities. Contemporary Accounting Research 12 (Spring): 689 731. . 1999. Residual earnings valuation with risk and stochastic interest rates. Accounting Review 74 (2): 165 83. Foster, G. 1986. Financial statement analysis. Englewood, NJ: Prentice-Hall. CAR Vol. 18 No. 4 (Winter 2001)
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Francis, J., P. Olsson, and D. Oswald. 2000. Comparing the accuracy and explainability of dividend, free cash ow and abnormal earnings equity value estimates. Journal of Accounting Research 38 (1): 45 70. Frankel, R., and C. Lee. 1998. Accounting valuation, market expectation, and crosssectional stock returns. Journal of Accounting and Economics 25 (3): 283 319. Gebhardt, W., C. Lee, and B. Swaminathan. 2001. Toward an implied cost of capital. Journal of Accounting Research 39 (1): 135 76. Huberman, G., and S. Kandel. 1987. Value Line rank and size. Journal of Business 60 (4): 577 89. Ibbotson, R., and R. Sinqueeld. 1983. Stocks, bonds, bills, and ination, 19261987. Charlottesville, VA: Financial Analysts Research Foundation. Kmenta, J. 1986. Elements of econometrics, 2nd ed. New York: Macmillan. Lundholm, R., and T. OKeefe. 2001. Reconciling value estimates from the discounted cash ow value model and the residual income model. Contemporary Accounting Research 18 (2): 311 35. Ohlson, J. 1995. Earnings, book values and dividends in equity valuation. Contemporary Accounting Research 12 (Spring): 661 87. Penman, S. 1997. A synthesis of equity valuation techniques and the terminal value calculation for the dividend discount model. Review of Accounting Studies 2 (4): 303 23. Penman, S., and T. Sougiannis. 1998. A comparison of dividend, cash ow, and earnings approaches to equity valuation. Contemporary Accounting Research 15 (3): 343 83. Peterson, D. 1995. The informative role of the Value Line Investment Survey: Evidence from stock highlights. Journal of Financial and Quantitative Analysis 30 (4): 607 18. Philbrick D., and W. Ricks. 1991. Using Value Line and IBES analyst forecasts in accounting research. Journal of Accounting Research 29 (2): 397-417. Sougiannis, T., and T. Yaekura. 2001. The accuracy and bias of equity values inferred from analysts earnings forecasts. Journal of Accounting, Auditing and Finance. Forthcoming. Stickel, S. E. 1992. Reputation and performance among security analysts. Journal of Finance 47 (5): 1811 37.

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Equity Valuation Employing the Ideal versus Ad Hoc Terminal Value Expressions*

Contemporary Accounting Research

Equity Valuation Employing Terminal Value Expressions

Contemporary Accounting Research

Equity Valuation Employing Terminal Value Expressions

Contemporary Accounting Research

Equity Valuation Employing Terminal Value Expressions

Contemporary Accounting Research

Equity Valuation Employing Terminal Value Expressions

Contemporary Accounting Research

Equity Valuation Employing Terminal Value Expressions

+ RT (R 1 g) 1E t [C t + T + 1 I t + T + 1 + i t + T + 1 (R 1) FA t + T ] We compute the numerator of the ad hoc terminal value expression as

Contemporary Accounting Research

Equity Valuation Employing Terminal Value Expressions

Contemporary Accounting Research

Equity Valuation Employing Terminal Value Expressions 5. Empirical results

Contemporary Accounting Research

Equity Valuation Employing Terminal Value Expressions

Skewness 1.624 1.557 1.454 1.613 1.771 1.623

Kurtosis 8.199 8.094 6.512 9.370 7.389 8.105

Kurtosis 21.069 20.109 3.151 7.409 11.180 8.541

Median, Median, $ % 11.95 11.72 0.04

Median, Median, $ % 32 31.513 31.479 1.95 1.41 0.27

Contemporary Accounting Research

DCF1 29.181 RIM1 29.104 Test of Hypothesis 1 DCF1 RIM1

Equity Valuation Employing Terminal Value Expressions

Signicant at the 1 percent level. Signicant at the 5 percent level.

Contemporary Accounting Research

0.10 0.08 0.06 0.04 0.02 0.00 0.02

Equity Valuation Employing Terminal Value Expressions

Contemporary Accounting Research

4.82 41.34 30.50

26 27.873 16.478 19.880

44.00 33.17 10.67 4.73 37.95 34.36

28.126 17.998 19.170

40.84 37.38 3.37

Median, Median, $ % 14.77 36.87 30.15

Median, Median, $ % 32 31.513 17.084 20.348 13.82 48.64 40.02

13.71 42.81 35.48

26 27.873 16.478 19.880

28.11 20.32 7.96 14.18 38.80 36.42

28.126 17.998 19.170

31.479 18.347 19.636

Equity Valuation Employing Terminal Value Expressions

CAR Vol. 18 No. 4 (Winter 2001)

25.55 22.62 2.61

Contemporary Accounting Research

TABLE 4 (Continued) Notes:

Signicant at the 1 percent level.

Equity Valuation Employing Terminal Value Expressions

CAR Vol. 18 No. 4 (Winter 2001)

Contemporary Accounting Research

CAR Vol. 18 No. 4 (Winter 2001)

0.162 0.966 93.71 %

0.598 0.950 93.04 %

Equity Valuation Employing Terminal Value Expressions

CAR Vol. 18 No. 4 (Winter 2001)

Signicant at the 1 percent level.

Price-based DTV t -stat. t -stat. H0: H0: Incremental Coefcient j = 0 j = 1 R2

15.61% 7.82% 45.81%

Contemporary Accounting Research

Price-based DTV t -stat. t -stat. H0: H0: Incremental Coefcient j = 0 j = 1 R2

0.521 0.962 0.909 0.945 92.79%