The Other Side of Equity Valuation: Unlock The Power of Expectations-Based Investing with a Reverse-Engineered Valuation Model

Abstract: Corporate valuations models have extensive use in practice and are cornerstones in the academic setting of finance. Traditional valuation models have the function to calculate the intrinsic value of a company on the basis of the forecasted performance of a company. However, due to the inaccuracy of forecasts, there is a need to uncover the other side of equity valuation, namely the expectations-based approach. Our study treads on the rather unexplored academic landscape of expectation investing by analyzing the market's expectations on equities performance Return on Equity (ROE) through a reverse-engineered Residual Income Valuation model (RIV-model), with the aim of answering the question; Can a reverse-engineered model be applied to assess the reasonableness of market valuation for investment purposes? To answer the research question, we performed a cross-industry analysis of the constituents in the S&P 500 index between the years 2011 to 2016 in an initial study, as well as a study of the latest financial figures of the year 2022. The results from the 1 803 observations of the two studies were that the model could be used to analyze the reasonableness of the market's expectations and that we could infer that markets were overvalued, with the exception of the Consumer Staple industry that was consistently undervalued according to our model.