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Equity Valuation Employing the Ideal versus Ad Hoc Terminal Value Expressions



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Equity Valuation Employing the Ideal versus Ad Hoc Terminal Value Expressions LUCIE COURTEAU Universit Laval JENNIFER L KAO University of Alberta GORDON D RICHARDSON University of Waterloo Abstract Recently Penman and Sougiannis 1998 and Francis Olsson and Oswald 2000 compared the bias and accuracy of the discounted cash flow model DCF and Edwards Bell Ohlson residual income model RIM in explaining the relation between value estimates and observed stock prices Both studies report that with non price based terminal values RIM outperforms DCF Our first research objective is to explore the question whether over a five year valuation horizon DCF and RIM are empirically equivalent when Penman s 1997 theoretically ideal terminal value expressions are employed in each model Using Value Line terminal stock price forecasts at the horizon to proxy for such values we find empirical support for the prediction of equivalence between these valuation models Thus the apparent superiority of RIM does not hold in a level playing field comparison Our second research objective is to demonstrate that within each class of the DCF and RIM valuation models the model that employs Value Line forecasted price in the terminal value expression generates the lowest prediction errors compared with models that employ non price based terminal values under arbitrary growth assumptions The results indicate Accepted by Jerry Feltham This paper was presented at the 2000 Contemporary Accounting Research Conference generously supported by the CGA Canada Research Foundation the Canadian Institute of Chartered Accountants the Society of Management Accountants of Canada the Certified General Accountants of British Columbia the Certified Management Accountants Society of British Columbia and the Institute of Chartered Accountants of British Columbia We would like to thank workshop participants at the 2000 American Accounting Association meetings 2000 Canadian Academic Accounting Association Conference 2000



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