Equity Valuation Using Multiples: An Empirical Investigation

Theoretical foundations 27affect the change in invested capital (Gode & Ohlson 2006, p. 4-5). This might alsobe one reason why sell-side analysts usually provide estimates of earnings ratherthan estimates of cash flows.3.1.3 Residual income valuation modelIn contrast, the RIV model derives forecasts for its key measure residual income(RI) – also referred to as abnormal earnings (AE) – directly from earningsforecasts. Ohlson (1995) defines residual income asequityRIt = NIt −r ⋅ Bt− 1(3.7)whereNItdenotes net income for the periodending at time t,RItis the residual income at time t,equityr is the cost of equity (assumed constant), andt 1B −is thebook value of common equity at time t − 1. The residual income is the amount thatnet income exceeds the capital charge on the book value of equity. The charge forthe use of capital can be viewed as the opportunity cost of invested capital (Peasnell1981, p. 54).Under the DDM, the intrinsic value of a firm’s equity equals the present valueof future expected dividends. By using an accounting identity between dividends,net income, and changes in the book value of equity, the value of a firm can be reexpressedas the present value of a combination of net income and book value ofequity. This accounting identity, called clean surplus relation, states that all changesin the book value of equity during a fiscal period are reflected in that period’s netincome or dividends distributed to common shareholders (O’Hanlon & Peasnell2002, p. 230-231). Formally,B − B = NI − D(3.8)t t−1t twhere Btis the book value of common equity at time t,for the period from t − 1 to t, andNItis the net incomeDtis the cash dividend paid to common share-