Equity Valuation Based on a Random Process Modelling of Earnings and Equity Growth

Abstract

The study reviews equity valuation, and proposes an alternative equity valuation model based on a random process modelling of earnings and equity growth. A Markov process is used to model earnings, standardized as earnings to book value, and book value based on rating category. This assumes a distinct relationship between rating category, and standardized earnings as well as book value: that both standardized earnings as well as book value are comparable per rating category, but distinct across rating categories. It is also assumed that a company inherits the earnings and book value distribution of its current rating. To test the premises of the equity valuation model, the study examines the standardized earnings and book value distributions of rating categories. The research population comprised all publicly-traded, rated equity of the JSE and NYSE stock markets. Sample data was limited to all equity of the major rating categories (AAA, AA, A, BBB, BB, B) for the 8 year window period 2009 to 2017. It is shown that earnings to book value are comparable per rating category, and distinct across rating categories. Analysis of book value growth revealed unexpected and surprising results, with no truly consistent pattern across rating categories, but rather individual relationships per rating category. The results raise questions regarding rating accuracy and rating theory. The implications of the results for equity valuation are discussed.