A Comparison Of Dividend Cash Flow And Earnings Approaches To Equity Valuation.pdf

A COMPARISON OF DIVIDEND, CASH FLOW, AND EARNINGS

APPROACHES TO EQUITY VALUATION

Stephen H. Penman

Walter A. Haas School of Business

University of California, Berkeley

Berkeley, CA 94720

(510) 642-2588

and

Theodore Sougiannis

College of Commerce and Business Administration

University of Illinois at Urbana-Champaign

Champaign, IL 61820

(217) 244-0555

January, 1995

Revision: April, 1996

We thank Pat O'Brien, Jim Ohlson, Mike Oleson, Morton

Pincus, Stephen Ryan, Jacob Thomas and Dave Ziebart for

comments.

ABSTRACT

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.

A COMPARISON OF DIVIDEND, CASH FLOW, AND EARNINGS

APPROACHES TO EQUITY VALUATION

The calculation of equity value is typically characterized as a

projection of future payoffs and a transformation of those payoffs into

a present value (price). A good deal of research on pricing models has

focused on the specification of risk for the reduction of the payoffs to

present value but little attention has been given to the specification

of payoffs. It is noncontroversial that equity price is based on future

dividends to shareholders but it is well-recognized that dividend

discounting techniques have practical problems. A popular alternative--

discounted cash flow analysis--targets future "free cash flows" instead.

Analysts also discuss equity values in terms of forecasted earnings and

the classical "residual income" formula directs how to calculate price

from forecasted earnings and book values. It is surprising that, given

the many prescriptions in valuation books and their common use in

practice, there is little empirical evaluation of these alternatives. 1

This paper conducts an empirical examination of valuation

techniques with a focus on a practical issue. Dividend, cash flow and

earnings approaches are equivalent when the respective payoffs are

predicted "to infinity," but practical analysis requires prediction over

finite horizons. The problems this presents for going concerns are well

known. In the dividend discount approach, forecasted dividends over the

immediate future are often not related to value so the forecast period

has to be long or an (often questionable) terminal value calculation

made at some shorter horizon. Alternative techniques forecast "more

fundamental" attributes within the firm instead of distributions from

the firm. However this substitution solves the practical problem only

if it brings the future forward in time relative to predicted dividends,

and these techniques frequently require terminal value corrections also.

In discounted cash flow (DCF) analysis the terminal value often has

considerable weight in the calculation but its determination is

sometimes ad hoc or requires assumptions regarding free cash flows

beyond the horizon. Techniques based on forecasted earnings make the

claim (implicitly) that accrual adjustments to cash flows bring the

future forward relative to cash flow analysis, but this claim has not

been substantiated in a valuation context.

The paper assesses how the various techniques perform in finite

horizon analysis. What techniques work best for projections over one,

two, five, eight year horizons and under what circumstances? A

particular focus is the question of whether the projection of accounting

earnings facilitates finite horizon analysis better than DCF analysis.

Analysts typically forecast earnings but, for valuation purposes, should

these be transformed to free cash flows? In classroom exercises

students are instructed to adjust forecasted earnings for the accruals

to "get back to the cash flows." This is rationalized by ideas that

cash flows are "real" and the accounting introduces distortions, but is

the exercise warranted?

The valuation techniques are evaluated by comparing actual traded

prices with intrinsic values calculated, as prescribed by the

techniques, from subsequent payoff realizations. Ideally one would

calculate intrinsic values from unbiased ex ante payoffs but, as

forecasts are not observable for all payoffs, intrinsic values are

calculated from average ex post payoffs. 2 Firm realizations are

averaged in portfolios and portfolio values are then pooled over time to

average out the unpredictable component of ex post realizations.

Intrinsic values calculated from these realizations are compared with

actual prices to yield ex post valuation errors and, if average

realizations represent ex ante expectations, estimates of ex ante errors

on which the techniques are compared. Both mean errors and the

variation of errors are considered as performance metrics. This

comparison is made under the assumption that, on average, actual market

prices with which calculated intrinsic values are compared are efficient

at the portfolio level with respect to information that projects the

payoffs.

Valuation techniques are characterized as pro forma accounting

methods with different rules for recognizing payoffs, and their relevant

features are identified within a framework that expresses them as

special cases of a generic accounting model. This framework refers to

the reconciliation of the infinite horizon cash flow and accrual

accounting models in Feltham and Ohlson (1995) and the finite-horizon

synthesis in Penman (1996). It establishes conditions where each

technique provides a valuation without error, with and without terminal

values, and identifies when (seemingly different) calculations yield the

same valuation. In particular, it demonstrates that DCF techniques with

"operating income" specified in the terminal value are identical to

models that specify accrual earnings as the payoff. Hence the

comparison of DCF techniques with accrual accounting residual income

techniques amounts to comparing different calculations of the terminal

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