A Comparison of Dividend, Cash Flow and Earnings Approaches to Equity Valution
Written by Paula Widiastuti, SE, MSM on 8/26/2008by. Stephen H. Penman and Theodore Sougiannis
Standard formulas for valuing equities require prediction of payoffs "to infinity" for going concerns but a practical analysis requires that they be predicted over finite horizons. This truncation inevitably involves (often troublesome) "terminal value" calculations. This paper contrasts dividend discount techniques, discounted cash flow analysis, and techniques based on accrual earnings when applied to a finite-horizon valuation. Valuations based on average ex post payoffs over various horizons, with and without terminal value calculations, are compared with (ex ante) market prices to give an indication of the error introduced by each technique in truncating the horizon. Comparisons of these errors show that accrual earnings techniques dominate free cash flow and dividend discounting approaches. Further, the relevant accounting features of each technique are identified and the source of the accounting that makes it less than ideal for finite horizon analysis (and for which it requires a correction) are discovered. Conditions where a given technique requires particularly long forecasting horizons are identified and the performance of the alternative techniques under those conditions is examined.
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