Equity Valuation : An examination of which investment valuation method appears to attain the closest value to the market price of a stock
PURPOSE- This paper empirically evaluate the ability among various types of parsimonious equity valuation models in order to ascertain which model represents the value of equity the best and thereby manage to withstand factors causing valuation errors. The more complicated models applied, the more underlying assumptions are needed. The trade-off here, which will be investigated, is if the benefit of using more difficult models outweighs the cost of including the extra assumptions. Further on the empirical research´s results will be compared with the results provided by this previous studies examinating American companies.
METHOD- Six valuation models using a discounting valuation method are evaluated; the Present Value of Expected Dividends (PVED), Residual Income Valuation (RIV), Residual Income Valuation Terminal Value Constrained [RIV(TVC)], Abnormal Earning Growth approach (AEG), Abnormal Earning Growth Terminal Value Constrained approach [AEG(TVC)] and Free Cash Flow to the Firm model (FCFF). The five latter investment models are all based on the first model.
FINDINGS- The aim of finding the smallest absolute valuation error in the empirical study is given to PVED, a model including little underlying assumptions and inputs. Hence, the implication of the application of valuation models can be summarized as that there are no clear benefits of applying complex models for Swedish companies, and the trade-off between using more complex models and thereby including more assumptions is not compelling given that the benefit does not exceed the cost. All the earnings methods are all found to be superior to the FCFF model, while the constrained RIV and AEG methods provide higher valuation errors than the unconstrained versions.
The superiority of the PVED model is inconsistent with the previous results examining American firms, in which the RIV model is preferred. One of the reasons for the difference is the use of different accounting standards in the counties, and thereby the companies´ capital structure and the inputs used in the investment valuation may be somewhat unlike.
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