Equity Valuation Using Multiples: An Empirical Investigation

Theoretical foundations 23Below, I summarize four fundamental equity valuation models: the dividenddiscount model (DDM), the discounted cash flow (DCF) model, the residual incomevaluation (RIV) model, and the abnormal earnings growth (AEG) model. The formerthree models are typically covered in valuation textbooks and business schoolclasses; the latter is a recent development of Ohlson (2005) and Ohlson & Juettner-Nauroth (2005).3.1.1 Dividend discount modelA shareholder’s payoffs from holding shares in a firm consist of the dividendpayments during the holding period as well as of the market value of the shareswhen selling them. Therefore, a firm’s value should be based on the stream of dividendsD1, D2,..., DTit is expected to pay in the future plus the market value ofequitycommon equity pTat the end of the forecast horizon T . If the forecast horizon isassumed infinite, the DDM, which is generally attributed to Williams (1938), formalizesthis notion and defines the intrinsic value of a firm as the present value ofexpected future dividends discounted at their risk adjusted expected rate of return.Formally,vequityt=E( D )∞t t+i∑ (3.1)ii=1 1equity( + rt+i )wherev is the firm’s intrinsic value of common equity at time t, ( )equitytE D +t t iis the expected future cash dividend in period t+i conditional on information availableat time t, and r equityt + iis the cost of equity in period t+i. A frequently neglectedassumption of the DDM – as well as of all the following equity valuation models inthis book – is that the transversality condition holds. That is, the expected (terminal)market value discounted at the appropriate cost of equity converges to zero as timeequityequitygoes to infinity limT→∞ Et( pt+ T ) ( rt+T )T/1+ = 0 (Spremann 2005, p. 59-61). Asseen from formula (3.1), value is dependent on the forecasts of future dividends anddiscount rates. Gordon (1962) makes simplifying assumptions about both the dividendprocess and discount rates to derive a simple valuation formula, which is re-