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International Research Journal of Finance and Economics ISSN 1450-2887 Issue 7 (2007) © EuroJournals Publishing, Inc. 2007 http://www.eurojournals.com/finance.htm Empirical Evidence on Retail Firms’ Equity Valuation Models Anastasia Vardavaki 13 Epidavrou str., Halandri, 152 33 Athens, Greece E-mail: anastasia_vardavaki@yahoo.gr John Mylonakis 10 Nikiforou str., Glyfada, 166 75 Athens, Greece E-mail: imylonakis@panafonet.r Abstract This paper presents the theoretical framework for the process o
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  International Research Journal of Finance and EconomicsISSN 1450-2887 Issue 7 (2007)© EuroJournals Publishing, Inc. 2007http://www.eurojournals.com/finance.htm Empirical Evidence on Retail Firms’ Equity Valuation Models Anastasia Vardavaki 13 Epidavrou str., Halandri, 152 33 Athens, Greece E-mail: anastasia_vardavaki@yahoo.gr  John Mylonakis 10 Nikiforou str., Glyfada, 166 75 Athens, Greece E-mail: imylonakis@panafonet.r  Abstract This paper presents the theoretical framework for the process of equity valuationand investigates the relative explanatory power of alternative linear equity valuationmodels when applied to firms in the UK food and drug retail sector. Due to practicaldifficulties in applying all valuation models, the empirical tests for the equity valuation are based on a) the asset-based model, which contains only book value as an independentvariable; b) the earnings-based model, and c) the combined model, which contains both book value and current earnings or abnormal earnings as value-relevant variables. Theresults of the empirical analysis support precious studies that the combined valuation modelis more informative by providing better and more accurate estimations of equity marketvalues. This can be explained by the fact that this model incorporates both the economicsand the accounting characteristics of the examined firms. Key words: Equity Valuation Models, Asset-Bards Model, Discounted Cash Flow Model,Discounted Residual Income, Equity Market Value JEL classification: G 380 1. Introduction Fundamental analysis entails the use of information in current and past financial statements, inconjunction with industry and macroeconomic variables in order to determine the firm’s intrinsicvalue. To a fundamental analyst, the market equity price tends to move towards the fundamental-intrinsic value. A difference between the current and the intrinsic value is an indicator of the expectedexcess rewards for investing in the security. A large body of research demonstrates that economicallysignificant abnormal returns spread over several years can be obtained by implementing fundamentalanalysis trading strategies.Equity valuation itself constitutes a fairly significant issue that has generated the intenseinterest of various economic and financial analysts. Valuation research has emerged as a central themein the accounting research of the 1990s. This literature has had a substantial impact on the researchagendas of academics and on the day-to-day work of practitioners. According to the ‘Efficient MarketHypothesis’, as defined by Fama (1970, 1991), security prices fully reflect all available information.Whether security markets are informationally efficient is of great interest to investors, shareholders,managers, lenders, standard setters and other market participants who care about intrinsic value of thefirm.  105  International Research Journal of Finance and Economics - Issue 7 (2007) There are several important valuation models that are applied for the purpose of determiningthe firm’s fundamental value. In an ideal world, where markets are perfect and efficient, the intrinsicfirm value equals the equity book value. However, in the real world, the book value of shareholder equity is generally lower than the market equity value. That is, the book-to-market ratio is less than theunity.The purpose of this paper is to present the theoretical framework of equity valuation models(Asset-Based, Discounted Cash Flow and Discounted Residual Income) and to empirically test thesevaluation models in a sample of UK food-drug retail companies, including a discussion of diagnostictests and some important econometric issues. 2. Theoretical framework on Equity Valuation Models Valuation is the process of forecasting the present value of the expected payoffs to shareholders and of converting this forecast into one number that corresponds to the fundamental-intrinsic firm value. Lee(1999) argues that valuation models are merely ‘pro forma accounting systems’ that constitute thevehicles for articulating the assessment of future events typically in terms of accounting constructs.According to Barker (2001), a good understanding of valuation methods requires two main things. Thefirst is an analytical review of the models, identifying their relationship and exposing their assumptions. The second is an evaluation of the data that are available for use of these models.Therefore, there is a significant relationship between the choice of valuation models and the availabledata. 2.1 Valuation Models Description There are some important theoretical valuation models which can be applied to equity valuation. In thissection the three types of valuation models most widely used are described: A. the Asset-Based Valuation Model, B. the Discounted Cash Flow Models which consist of three sub categories, the Free Cash Flow,the Dividend-Based and the Earnings-Based Model and finally C. the Discounted Residual Income or Edwards-Bell-Ohlson (EBO) Model A. Asset Based Valuation Model assigns a value to the firm based on the fair value of individualcomponent assets. Liabilities (also at fair prices) are deducted to arrive at the value of the firm’s equity.This model can be applied when balance sheets are perfect, that is, the assets and liabilities arerecorded at fair market value. Since they are priced efficiently in the market, they will earn at their costof capital. In this case, intrinsic value equals book value and the expected future residual income iszero. Residual income for period t  is defined as the comprehensive earnings available to commonequity for the period less a charge against the earnings for the book value at the beginning of the period   B t-1 , earning at the cost of capital. Therefore, when there is neither unrecorded goodwill nor omittedvalue, the asset-based valuation model defines the firm value * t  V  as the sum of fair values of nettangible and intangible assets: ∑ ∞= = 1* iit   fvV   This model is most applicable to value net financial obligations which are recorded at marketvalue but not to value net operating assets since some of them are measured at depreciated historicalcost (such as property, plant, equipment) and some at zero value (omitted knowledge assets and other intangibles). Therefore, this model can be used to value firms with large fixed assets and firmsapplying simple technology. B. Discounted Valuation Models assign a value to the firm that equals the present value of expectedfuture accounting measures, based on all currently available information. The parameters that make up   International Research Journal of Finance and Economics - Issue 7 (2007) 106Discounted Valuation Models are related to risk (the required rate of return) and the return itself ( it  CF  +  which are the cash flows), as: ∑ ∞=+ +≡ 1* )1()( iieit t t  r CF  E V   These models use three alternative cash flow measures: a) free cash flows, b) dividends and c)accounting earnings. Under the assumption of perfect markets, these models give the same results asthe asset-based valuation model.a) Free Cash Flow Model assumes that the firm’s value equals the present value of cash flowsfrom all the projects in its operations. Free cash flow is the difference between the cash flow fromoperations and cash investment. It is the cash available to debt and equity holders after investment. TheFree Cash Flow Model (FCF) is specified by Copeland, Koller and Murrin (2000) as: t t t ii f t t t   PS  D ECMS r  FCF  E V  −−++≡ ∑ ∞= 1* )1()(  where   * t  V  the market value of equity at time t,  f  r  the weighted average cost of capital, t   ECMS  theexcess cash and marketable securities, t   D the market value of debt and t   PS  the market value of  preferred stock at time t. b) Dividend Discount Model assumes that a stock's fundamental equity value can be defined asthe present value of its expected future dividends based on all currently available information. ∑ ∞=+ +≡ 1* )1()( iieit t t  r  D E V   In this definition, * t  V  is the stock's fundamental value at time t, )( it t   D E  + are the expected futuredividends for period t+i conditional on information available at time t, and e r  is the cost of equitycapital based on the information set at time t. This definition assumes a flat term-structure of discountrates.c) Under Earnings-Based Valuation Approach, a firm’s equity value can be expressed as thesum of the expected earnings, discounted at an appropriate risk-adjusted discount rate: ∑ ∞=+ +≡ 1* )1()( iieit t t  r  X  E V   In the case that the expected future annual income level )(  X  E  t  is constant, the ‘capitalizationof earnings’ approach can be applied: ** )( r  X  E V  t t  ≡   where r* is the risk adjusted capitalization rate. Unlike the asset-based approach, this model cancapture unrecorded goodwill, that is, the difference between the book value and market value of thefirm’s assets. The earnings-based model is often applied to firms such as technology intensive firms(computer firms, telecommunication firms) that have considerable unrecorded intangible assets andhigh expected future cash flows. C. Discounted- Residual Income Model, sometimes referred to as Edwards-Bell-Ohlson (EBO), isgenerally considered to be the most reliable model for equity valuation. It provides a way of thinkingabout value generation in the business. It is an accrual accounting model where the central concept isthe residual income, a measure of accounting income in excess of a normal/required return on capitalemployed. As far as the model of Ohlson (1995), the parameters that make up the Discounted ResidualIncome Model are: ∑∑ ∞=−++∞=−++ +−+≡+−+≡ 1111* )1(]*)[( )1()]*([ iieit eit t  t iieit eit t  t t  r  Br  ROE  E   Br  Br  NI  E   BV     107  International Research Journal of Finance and Economics - Issue 7 (2007)where    B t    is the book value at time t  , 1 −+ it   B is the beginning-of-year book value at t, Et  [.] is expectation based on information available at time t, NI  t+i is the Net Income for period t+i , r  e is the cost of equitycapital and  ROE  t  +i is the after-tax return on book equity for period t+i .This is the Residual Income Model (RIM) which shows that equity value can be split into twocomponents: an accounting measure of the capital invested (  B t  ), and a measure of the present value of future residual income, defined as present value of future discounted cash flows not captured by thecurrent book value. If a firm earns future accounting income at a rate exactly equal to its cost of equitycapital, then the present value of future residual income is zero, and V  t  =B t  . In other words, firms thatneither create nor destroy wealth relative to their accounting-based shareholders' equity, will be worthonly their current book value. However, firms with expected ROEs higher (lower) than r  e will havevalues greater (lower) than their book values. Therefore, the RIM is a combination between asset-basedvaluation model for firm’s financial activities and earnings-based model for operating activities. Sinceit incorporates firm’s stock and flow components, it is most applicable to companies with high fixedand intangible assets and whose values are generated by both assets and future stream of earnings. 2.2 Comparison of Valuation Models Several authors have shown that there is a theoretical equivalence between the free cash flow model,the dividend discount model and the residual income model. Plenborg (2000) states that these valuationtechniques should give consistent and identical estimates of intrinsic firm value, provided that all theforecasts of the different items are consistent with each other within a clean surplus relationship and allthe assumptions are identical. Moreover, for all sets of accounting rules, these models produce thesame valuation when infinite-horizon forecasts are used. Thus, the dividend, cash flow and residualincome approaches are equivalent when the respective payoffs are predicted to infinity.However, these zero-error conditions are very restrictive. In practice, forecasts are made over finite horizons so different accounting principles yield different estimates with finite-horizon forecasts.For this reason, steady state terminal values, which usually have considerable weight in equityvaluation, are calculated in practice to correct for error introduced by the truncated forecast horizonand such calculations are necessary for all clean-surplus accounting methods. Specifically, Levin andOlsson (2000) argue that the steady state conditions ensure that the company’s forecasted performanceremains stable after the valuation horizon and that its expected development, as described by its parameters, holds indefinitely. They also claim that steady state is a necessary condition for the threemodels to yield identical results when terminal values are used. Therefore, any steady state conditionviolation can cause internal inconsistencies in valuation models and thus have a significant effect onthe equity value estimates.Furthermore, according to Olsson (1998), valuation models give different value estimates whendifferent simplifying assumptions are introduced, since these assumptions introduce bias in the firmvalue estimates. At this point it should be mentioned that Penman and Sougiannis (1998) and Francis,Olsson and Oswald (2000) do not take into account the fact that the same assumptions must be appliedto the models so that they yield identical valuations. The use of simplifying assumptions in both studiesmakes the link between the forecasted financial statements and the input in the different valuationapproaches most likely inconsistent. Based on these distinct assumptions, both studies suggest thatRIM is superior to the other models. Therefore, these two studies indicate that if the internal coherence between the three valuation models is violated, the RIM yields more accurate firm value estimates thanthe FCF or the DDM, most likely due to the use of different assumptions. Nevertheless in practice, there are a number of potential advantages of the Residual Income(accounting-based) approach to valuation:i)   The cash flow-based approaches measure the expected distribution of wealth by the business toits investors. In contrast, accounting-based models provide a way of thinking about a businessand about value generation in the business. It focuses on profitability of investment (reflected bythe return on common equity) and growth in investment (given by the increase in book equity
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