The accuracy of equity valuation methods

Abstract

The accurate valuation of companies is a primary concern for anyone involved in valuing firms. However, studies implementing different valuation methods frequently find deviations of more than 50% between value estimates and observed market values. One interpretation of these results is that capital markets are grossly inefficient. A more plausible alternative explanation is that it is difficult to obtain perfect estimates of future payoffs and/or cost of capital. As outlined in Figure 1 in Section 1.2, I therefore try to analyze why valuations are apparently so inaccurate and how they may become more accurate. The analysis in this chapter is based on a review of the empirical literature on the valuation errors of equity valuation models. Such a review of the literature is useful for several reasons. Most importantly, for many practitioners their choice of valuation method depends - amongst other factors - on the assumed valuation accuracy of this method. However, I am not aware of any comprehensive review on the empirical performance of different types of valuation models. Hence, the review presented in this chapter may help researchers and practitioners to assess the relative and absolute performance they may expect from different valuation methods under different settings. With respect to the second research question, I want to investigate which factors affect valuation errors and whether some valuation methods are more accurate than others. Most importantly, I believe that valuation accuracy is not fixed or stationary but rather depends on a number of factors. Therefore, the second aim of this review is to help researchers and practitioners to evaluate which factors affect valuation accuracy and to what extent they do so. Finally, to address the third research question, I derive best practice approaches for different valuation methods.