Equity Valuation

PURPOSEThis paper empirically evaluate the ability among various types of parsimonious equity valuation models in order to ascertain which model represents the value of equity the best and thereby manage to withstand factors causing valuation errors. The more complicated models applied, the more underlying assumptions are needed. The trade-off here, which will be investigated, is if the benefit of using more difficult models outweighs the cost of including the extra assumptions. Further on the empirical research ́s results will be compared with the results provided by this previous studies examinating American companies. METHODSix valuation models using a discounting valuation method are evaluated; the Present Value of Expected Dividends (PVED), Residual Income Valuation (RIV), Residual Income Valuation Terminal Value Constrained [RIV(TVC)], Abnormal Earning Growth approach (AEG), Abnormal Earning Growth Terminal Value Constrained approach [AEG(TVC)] and Free Cash Flow to the Firm model (FCFF). The five latter investment models are all based on the first model. FINDINGSThe aim of finding the smallest absolute valuation error in the empirical study is given to PVED, a model including little underlying assumptions and inputs. Hence, the implication of the application of valuation models can be summarized as that there are no clear benefits of applying complex models for Swedish companies, and the trade-off between using more complex models and thereby including more assumptions is not compelling given that the benefit does not exceed the cost. All the earnings methods are all found to be superior to the FCFF model, while the constrained RIV and AEG methods provide higher valuation errors than the unconstrained versions. The superiority of the PVED model is inconsistent with the previous results examining American firms, in which the RIV model is preferred. One of the reasons for the difference is the use of different accounting standards in the counties, and thereby the companies ́ capital structure and the inputs used in the investment valuation may be somewhat unlike. Abbreviations In order to simplify the notation, the following abbreviations are used; Abs(V.E) = Absolute Valuation Error AEG = Abnormal Earnings Growth model AEG(TVC)= Abnormal Earnings Growth model Terminal Value Constrained βSn = Equity beta for security n Bvt = Book value of share at time t, after capital transactions at time t Cbt = Conservative valuation bias at time t in equity of the company Cov ( Sn,M ) = Covariance between security Sn and market portfolio (OMX30) CSR = Clean surplus relation D = The company ́s amount of debt Divt = The dividend paid out at time t E = The company ́s amount of Equity EBIT = Earnings Before Interest and Tax Et(.)= Expectation operator at time t FCFF= Free Cash Flow to the Firm model g = Company ́s Growth rate in earnings in the steady state of the firm GAAP = Generally Accepted Accounting Principles HA = Alternative hypothesis H&M= Hennes and Mauritz HO = Null hypothesis IFRS = International Financial Reporting Standards k = Dividend payout ratio Mi = Observation i for the market portfolio N = Total number of observations Pt = Price of the stock at time t, the market price PVED= Present value of Expected Dividends (also called the dividend discount model) PVEE= Present Value of Expected Earnings PWC = Price Waterhouse Coopers rD = Required rate of return by the debt holders rE = Required rate of return of the equity holders RE = rE + 1 rF = Risk free rate RIV= Residual Income Valuation RIV(TVC) = Residual Income Valuation Terminal Value Constrained rM = Return of the market (based on the market portfolio) rP = rF – rM, The market risk premium, i.e. the extra return required by investors for holding a risky securities rather than a risk-free security rwacc = Weighted Average Cost of Capital Rwacc = rwacc + 1 SCA= Svenska Cellulosa Akitebolaget SEB= Skandinaviska Enskilda Banken Sn = Security n T= Tax rate UB = Unbiased accounting Var(M) = Variance of the market Var(Sn) = Variance of security n V.E = Valuation Error Vt = Value of the firm given by the investment model at time t Xt = Accounting net earnings accumulated over the period Yi = Observation i for security n μSn = The mean for security n ν = The mean of the market index