Equity Valuation with Heterogeneous Beliefs

Niu Weining

doi:10.13189/ujaf.2021.090209

Abstract

Residual income model in equity valuation has emerged as a useful reference for investment decisions on account of its theoretical foundations for analytical accounting research and also the basis of modelling for empirical study on value relevance. However, since investors have disagreement on firm's future earnings, it may have an effect on firm's evaluation and hence affect stock price. The paper extends the residual income model by incorporating investors' heterogeneous beliefs on the persistence of residual income, and then tests the theoretical findings through numerical simulation. The model implies that the relation between stock price and heterogeneous beliefs depends on the sign of residual income, and the impact of informed traders on stock price relies on the interaction effect of heterogeneous beliefs and residual income. The numerical simulation results prove that under the circumstance of positive heterogeneous beliefs, if residual income is also positive, stock price has a positive relation with heterogeneous beliefs and amount of informed investor; while if residual income is negative, stock price has a negative relation with heterogeneous beliefs and informed trading. The findings of the paper provide some useful theoretical implications on the effect of heterogeneous beliefs on equity valuation via residual income framework. Research limitations mainly exist in the strict theoretical assumptions, which can be loosen in further researches to make the model closer to real market.

Highlights

Equity valuation is a core issue in corporate finance research area, and there are plenty of theoretical models for valuation, e.g. Dividend Discount Model (DDM), Free Cash-Flow Model (FCFM), Residual Income Model (RIM), Options-Based Model (ROM), etc
Feltham and Ohlson [2] divided firm’s activities into both financial and operating activities, and assumed that the market value of financial assets equaled book value in a perfect market, and proposed an extended model that equity value equaled the book value of financial assets plus the present value of free cash flows expected from operating activities
Since RIM has been extensively discussed in both academic research and practical application, for instance, Richardson and Tinaikar [4] provided a brief review of researches on accounting based valuation models and its applications; Zhang [5] gave a more systematic and comprehensive review on the valuation literature based on those three milestone works in the past decades, and suggested future directions for further developing valuation theory and related empirical research

Summary

Introduction

Equity valuation is a core issue in corporate finance research area, and there are plenty of theoretical models for valuation, e.g. Dividend Discount Model (DDM), Free Cash-Flow Model (FCFM), Residual Income Model (RIM), Options-Based Model (ROM), etc. Ample literatures in behavioral finance (surveyed in Shleifer [6]; Xiong [7]) indicate that market participants are not always rational, and they have different opinions on assets’ future payoff These disagreements, known as heterogeneous beliefs, arise from gradual information flow, limited attention and heterogeneous priors (Hong and Stein [8]). For other situations 2(ii), 2(iii), and 2(iv), the implications are similar

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Numerical Simulation

Conclusions