Educational - A COMPARISON OF DIVIDEND, CASH FLOW, AND EARNINGS APPROACHES TO EQUITY VALUATION
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A COMPARISON OF DIVIDEND, CASH FLOW, AND EARNINGS APPROACHES TO EQUITY VALUATION
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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January 22nd, 2017
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