A Comparison of Dividend, Cash Flow, and Earnings Approaches to Equity Valuation *

A Comparison of Dividend, Cash Flow, and Earnings Approaches to Equity Valuation * Standard formulas for valuing the equity of going concerns require forecasting payoffs to infinity but practical analysis requires that payoffs be forecasted 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 each is applied with finite‐horizon forecasts. Valuations based on average ex post payoffs over various horizons, with and without terminal value calculations, are compared with ex ante market prices to discover the error introduced by each technique in truncating the horizon. Valuation errors are lower using accrual earnings techniques rather than cash flow and dividend discounting techniques. The accounting features that make a given technique less than ideal for finite horizon analysis are also detailed. Conditions where a given technique requires particularly long forecasting horizons are identified and the performance of the alternative techniques under those conditions is examined. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Contemporary Accounting Research Wiley

A Comparison of Dividend, Cash Flow, and Earnings Approaches to Equity Valuation *

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Publisher
Wiley
Copyright
1998 Canadian Academic Accounting Association
ISSN
0823-9150
eISSN
1911-3846
DOI
10.1111/j.1911-3846.1998.tb00564.x
Publisher site
See Article on Publisher Site

Abstract

Standard formulas for valuing the equity of going concerns require forecasting payoffs to infinity but practical analysis requires that payoffs be forecasted 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 each is applied with finite‐horizon forecasts. Valuations based on average ex post payoffs over various horizons, with and without terminal value calculations, are compared with ex ante market prices to discover the error introduced by each technique in truncating the horizon. Valuation errors are lower using accrual earnings techniques rather than cash flow and dividend discounting techniques. The accounting features that make a given technique less than ideal for finite horizon analysis are also detailed. Conditions where a given technique requires particularly long forecasting horizons are identified and the performance of the alternative techniques under those conditions is examined.

Journal

Contemporary Accounting ResearchWiley

Published: Sep 1, 1998

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