Drivers to Equity Valuation: Perpetuities or Annuities Approach? An Application to the main European Stock Markets
Keywords:
Annuity, Perpetuity, Equity valuation, DCF, RIM, DDM
Abstract
Academics and practitioners have been applying equity valuation methods mainly based on discount cash flow models, residual income models or dividend discount models combined with balance sheet and income statement multiples of market comparables to analyse share price and to provide price targets for investors or even base for transactions such as mergers and acquisitions (M&A). Most of those methods rely on mathematical deductions of growing or constant perpetuities or near perpetuities (such as annuities) to attain market values. However, it is of the outmost relevance for valuation to verify how the theoretical models relate with real values and what is its relationship with companies’ firm past age. Beyond stating a non-linear relationship for valuation models and ascertain important valuation drivers, using a sample of more than 3400 European companies with cross section data, this paper contributes to the improvement of valuation model’s effectiveness by inducing non-explicit period valuation modifications to long term annuities and perpetuities considering class age intervals. This paper’s originality is supported by the study of the relation of past company age with predicted annuities, the proof of non-compliance of perpetuity-based valuation models and the contribution with new value drivers for valuation purposes.Downloads
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References
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Reis, P.N. & Augusto, M.G. (2014a). Determinants of Firm Terminal Value: The Perspective of North American and European Financial Analysts. International Business & Economics Research Journal, 4(13), 793-808.
Reis, P.N. & Augusto, M.G. (2014b). What Is a Firm’s Life Expectancy? Empirical Evidence in the Context of Portuguese Companies. Journal of Business Valuation and Economic Loss Analysis, 1(10), 45-55.
Ritter, J. & Warr, R. (2002). The Decline of Inflation and the Bull Market of 1982–1999, Journal ofFinancial and Quantitative Analysis, 37(1), 29–61.
Sahoo, S., & Rajib, P. (2013). Comparable firm’s P/E multiple and IPO valuation: an empirical investigation for Indian IPOs. Decision, 40(1-2), 27-46.
Arslan, M., & Zaman, R. (2014). Impact of Dividend Yield and Price Earnings Ratio on Stock Returns: A Study Non-Financial listed Firms of Pakistan. Research Journal of Finance and Accounting, 5(19), 2222–2847.
Ballestra, L. V., Pacelli, G., & Radi, D. (2018). Valuing investment projects under interest rate risk : empirical evidence from European firms. Applied Economics, 49(56), 5662–5672.
Bancel, F., & Mittoo, U. R. (2014). The Gap between Theory and Practice of Firm Valuation : Survey of European Valuation Experts. Journal of Applied Corporate Finance, 26(4), 106–117.
Bhargava, V., & Malhotra, D. K. (2006). Do Price-Earnings Ratios Drive Stock Values? Journal of Portfolio Management, 33(1), 86–92.
Bradley, M., & Jarrell, G. A. (2008). Expected Inflation and the Constant‐Growth Valuation Model. Journal of Applied Corporate Finance, 20(2), 66-78.
Brealey, R. A. & Myers, S. C. (2000). Principles of corporate finance. Irwin/Mcgraw-hill.
Chi, J. D., Su, X., Chang, S., Coles, J., Durguner, S., Eckbo, B. E., & Harford, J. (2017). The Dynamics of Performance Volatility and Firm Valuation, 52(1), 111–142.
Coad, A., Holm, J. R., Krafft, J., & Quatraro, F. (2015). Firm age and performance. Journal of Evolutionary Economics, 28(1), 1-11.
Koller, T., Goedhart, M., & Wessels, D. (2010). Valuation: measuring and managing the value of companies (Vol. 499). John Wiley and sons.
Copeland, T. E.; Koller, T. & Murrin, J. (2000). Valuation: Measuring and Managing the Value of Companies. Mckinsey company Inc.
Demirakos, E. G., Strong, N. C., & Walker, M. (2004). What valuation models do analysts use? Accounting Horizons, 18(4), 221–240.
Dempsey, M. (2013). Consistent cash flow valuation with tax‐deductible debt: A clarification. European Financial Management, 19(4), 830-836.
Elsner, S. & Krumholz, H. (2013). Corporate valuation using imprecise cost of capital. Journal of Business Economics, 83, 985–1014.
Fernandez, P. (2002). Valuation methods and shareholder value creation. Academic Press.
Fernandez, P. (2010). WACC: Definition, Misconceptions, and Errors. Business Valuation Review, 29(4), 138–144.
Fernandez, P. (2013). Price to Earnings Ratio, Value to Book Ratio and Growth. SSRN Electronic Journal, 27. https://doi.org/10.2139/ssrn.2212373
Foster, G., Kasznik, R., & Sidhu, B. K. (2012). International equity valuation: The relative importance of country and industry factors versus company‐specific financial reporting information. Accounting & Finance, 52(3), 767-814.
Frankel, R., Lee, C. M. C.. (1998). Accounting Valuation, Market Expectations, and Cross-Sectional Stock Returns. Journal of Accounting Economics, 25, 283–319.
Friedl, G., & Schwetzler, B. (2011). Terminal value, accounting numbers and inflation. Journal of Applied Corporate Finance, 23(2), 104–112.
Front Matter. (1980). Journal of the Royal Statistical Society. Series C (Applied Statistics), 29(1). Retrieved from http://www.jstor.org/stable/2346401.
Fuller, R.J. and Hsia, C. (1984). “A simplified common stock valuation model”, Financial Analysts Journal, 40(5), 49-56.
Gordon, M. J., & Shapiro, E. (1956). Capital equipment analysis: the required rate of profit. Management science, 3(1), 102-110.
Green, J., Hand, J. R., & Zhang, X. F. (2016). Errors and questionable judgments in analysts’ DCF models. Review of Accounting Studies, 21(2), 596-632.
Hamadi, H., & Hamadeh, M. (2012). Equity valuation: a comparison between the discounted cash flow models and the residual, 6(2), 104–116.
Herz, H., Iannaconi, T. E., Maines, L. A., Palepu, K., Ryan, S.T., Schipper, K., Schrand, C.M., Skinner, D.J., Vincent, L. (2001). Equity Valuation Models and Measuring Goodwill Impairment, Accounting Horizons,15(2),161-70.
Huang, A. G. (2009). The cross section of cashflow volatility and expected stock returns. Journal of Empirical Finance, 16(3), 409–429.
Hussainey, K., Oscar Mgbame, C., & Chijoke‐Mgbame, A. M. (2015). Dividend policy and share price volatility. Investment Management and Financial Innovations, 12(1), 57–68.
Imam, S., Chan, J., & Shah, S. Z. A. (2013). Equity valuation models and target price accuracy in Europe: Evidence from equity reports. International Review of Financial Analysis, 28, 9-19.
Jan, C. L., & Ou, J. A. (2011). Negative-book-value firms and their valuation. Accounting horizons, 26(1), 91-110.
Jatmiko, D. P. (2015). The relationship between return, price to earnings ratio, price to book value ratio, size and beta in different data period. Investment Management and Financial Innovations, 12(1), 47–59.
Kohlbeck, M., & Mayhew, B. W. (2010). Valuation of firms that disclose related party transactions. Journal of Accounting and Public Policy, 29(2), 115–137.
Krüger, P., landier, a., & Thesmar, D. (2015). The WACC Fallacy: The Real Effects of Using a Unique Discount Rate. The Journal of Finance, 70(3), 1253–1285.
Mathilda, M. (2012). Pengaruh price earnings ratio dan price to book value terhadap return saham indeks LQ 45. Jurnal Akuntansi, 4(1), 1–21.
Meitner, M. (2013). Multi-period Asset Lifetimes and Accounting-based Equity Valuation: Take Care with Constant-growth Terminal Value Models! Abacus, 49(3), 340–366.
Mitra, R. K. (2016). The association between earnings quality and firm-specific return volatility. Review of Accounting and Finance, 15(3), 294–316.
Mitra, S. K. (2011). Revisiting WACC. Global Journal of Management and Business Research, 11(11), 89–96.
O’hanlon, J., & Peasnell, K. (2004). Residual income valuation: Are inflation adjustments necessary?. Review of Accounting Studies, 9(4), 375-398.
Ohlson, J. A. (1995). Earnings, book values, and dividends in equity valuation. Contemporary accounting research, 11(2), 661-687.
Ou, J. A., & Sepe, J. F. (2002). Analysts earnings forecasts and the roles of earnings and book value in equity valuation. Journal of Business Finance and Accounting, 29(3–4), 287–316.
Penman, S. (2011). Accounting for Risk and Return in Equity Valuation Morgan. Applied Corporate Finance, 23(2), 50–58.
Penman, S. H. (1998). A synthesis of equity valuation techniques and the terminal calculation for the dividend discount model. Review of Accounting Studies, 2(4), 303-323.
Penman, S. H., & Sougiannis, T. (1998). A comparison of dividend, cash flow, and earnings apporaches to equity valuation. Contemporary Accounting Research, 15(3), 343–383.
Reis, P.N. & Augusto, M.G. (2013). Determinants of Terminal Value in the Evaluation of Companies: A Panel Data Approach to the Context of European Companies. International Research Journal of Finance and Economics, 138(117), 9-118.
Reis, P.N. & Augusto, M.G. (2014a). Determinants of Firm Terminal Value: The Perspective of North American and European Financial Analysts. International Business & Economics Research Journal, 4(13), 793-808.
Reis, P.N. & Augusto, M.G. (2014b). What Is a Firm’s Life Expectancy? Empirical Evidence in the Context of Portuguese Companies. Journal of Business Valuation and Economic Loss Analysis, 1(10), 45-55.
Ritter, J. & Warr, R. (2002). The Decline of Inflation and the Bull Market of 1982–1999, Journal ofFinancial and Quantitative Analysis, 37(1), 29–61.
Sahoo, S., & Rajib, P. (2013). Comparable firm’s P/E multiple and IPO valuation: an empirical investigation for Indian IPOs. Decision, 40(1-2), 27-46.
Published
2020-01-12
How to Cite
Nogueira Reis, P., & Augusto, M. (2020). Drivers to Equity Valuation: Perpetuities or Annuities Approach? An Application to the main European Stock Markets. Journal of Business, Universidad Del Pacífico (Lima, Peru), 11(1), 27-48. https://doi.org/https://doi.org/10.21678/jb.2019.986
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