An Empirical Evaluation of the Discounted Cash Flow Model and Residual Income Model in Equity Valuation

Jadallah, Saleem (2011) An Empirical Evaluation of the Discounted Cash Flow Model and Residual Income Model in Equity Valuation. [Dissertation (University of Nottingham only)] (Unpublished)

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The collapse of the world markets hinted at the significant overestimation of assets on the market. Assets have been mismanaged and severe losses have been incurred. There has since been renewed interest in fundamental valuation models as they are believed to capture a more complete view of firm value. In this paper, we follow up on this renewed interest by empirically analysing the performance and explanatory power of two major present value models, the Discounted Cash Flow model (DCF) and the Residual Income Model (RIM), and in the process, concluding which model works best in the valuation of equity.

This paper examines the reliability and accuracy of the DCF and RIM under finite valuation horizons. Empirical tests are performed on 21 large-cap firms from the NASDAQ-100 index for the period 2000-2009. Specified ex-post financial data inputs are extracted from individual firm financials and used in each model accordingly. Prediction errors are calculated using ex-post share prices of the 21 firms on the valuation date as performance benchmarks. Regression analyses are performed to explain cross sectional variation between the models and observed share prices. It is concluded that the accounting based RIM serves as a more reliable and accurate valuation model under most assumptions. The use of accrual accounting data as earnings benchmarks is found to capture value relevant information the DCF inherently ignores, thus producing superior results. Moreover, the RIM enjoys a slight advantage in explanatory power over the DCF.

Item Type: Dissertation (University of Nottingham only)
Depositing User: EP, Services
Date Deposited: 25 Apr 2012 14:13
Last Modified: 10 Jan 2018 18:09

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