Using mechanical earnings and residual income forecasts in equity valuation

Accounting

Accounting Working Paper

2000

We document the reliability of value estimates based on forecasts from firm-specific mechanical models of residual income and of earnings. Reliability refers to the signed and absolute deviation between value estimates and observed market prices, and to the ability of value estimates to explain variation in prices (or the ability of book-scaled value estimates to explain variation in market-to-book ratios). For a large sample of firms over 1976-1997, we find that firm-specific time-series models of residual income generate estimates of intrinsic values which are significantly less biased, at least as accurate, and explain at least as much, if not significantly more, of the variation in observed prices and market-to-book ratios than do value estimates based on firm-specific time series models of earnings or value estimates based on book value of equity alone. For a sample of firms followed by analysts over 1981-1997, we compare mechanical-based residual income value estimates with analyst-based value estimates. Analyst-based value estimates are significantly less biased, but are not more accurate and do not explain more of the variation in prices than mechanical residual income value estimates. The result that firm-specific models of residual income generate relatively reliable measures of intrinsic value differs from prior studies which assume constant persistence and find that mechanicalbased residual income value estimates do not improve on book values alone (Dechow, Hutton and Sloan [1999]) and are dominated by analyst-based value estimates (Frankel and Lee [1998]). We show that the difference in results is due to relaxing the assumption that the persistence in residual income is an overtime and cross-sectional constant.

ACCT 010

Accounting Working Paper

No