This paper examines three basic equity valuation concepts: (1) residual income valuation (RIV); (2) in the spirit of Miller-Modigliani, the irrelevance of a firm's dividend payout policy; (3) betas/CAPM, to quantify risk and capitalization factors. As a first cut, results show that RIV, concept (1), lacks empirical support while in contrast concepts (2) and (3) hold up reasonably well. To address (2) and (3) we develop a model where earnings and earnings growth determine value. This model supplants RIV because of its greater intuitive appeal and empirical support. A linear function of eps1, eps2, dps1 maps into stock prices and theory specifies the coefficients' admissible magnitudes. Both the concepts of dividend payout irrelevance and risk (cost-of-equity per CAPM) restrict the coefficients. Bvps is value-irrelevant, in both the analytical and empirical analyses. The latter can be viewed as a case study; it considers S&P500 firms at two points in time, and the data was hand-collected in real time from a public website (Yahoo!Finance). This scheme ensures perfectly synchronized data and it usefully provides not only consensus forecasts but also real time betas. Overall, the paper contributes by developing valuation concepts and by showing how these can be evaluated empirically.
- Earnings and earnings growth model
- Residual income
ASJC Scopus subject areas