Equity Valuation Using Multiples: An Empirical Investigation

Theoretical foundations 29counting is conservative (Gode & Ohlson 2006, p. 5). It is well to note that RIVdoes not conform to principles of equity valuation as we generally observe them inpractice. Only few practitioners view current book value of equity as a starting pointin valuation; the majority tends to focus on (future) earnings and earnings growth(Ohlson 2002, p. 248).3.1.4 Abnormal earnings growth modelAlthough expected earnings and earnings growth are popular among analystsand investment bankers, theoretical cognition on earnings-based valuation is rare.The Ohlson (2005) and Ohlson & Juettner-Nauroth (2005) abnormal earningsgrowth (AEG) model legitimizes the common practice of using earnings estimates.Indeed, it shows how to convert analysts’ earnings forecasts to a valuation formula,which rely neither on the clean surplus relation nor on book value of equity.Given the clean surplus relation (and the notification) of equation (3.8), AEGat time t is equal to the change in residual income between t − 1 and t (line one andtwo in equation (3.10)). For a constant cost of equity requity , it is possible to expressAEG without the book value of equity by rearranging terms.AEG = RI −RIt t t−1= NI −r ⋅B − NI −r ⋅Bequity( )equity( ( ))equityt t−1 t−1 t−2= NI −r ⋅B − NI −r ⋅ B − NI + Dequityt t−1 t−1 t−1 t−1 t−1= NI −r ⋅B − NI + r ⋅B −r ⋅ NI + r ⋅Dequity equity equity equityt t−1 t−1 t−1 t−1 t−1equityequity= NIt+ r ⋅Dt−1− ( 1+ r ) ⋅NIt−1(3.10)Any firm as a going concern must eventually reach a steady state, where itdoes not earn abnormal earnings. Otherwise, per definition, its intrinsic value wouldbe infinite. At this certain point in time RIt= 0 andNItB = t− 1 equityr(3.11)