Performance evaluation of two earnings based valuation models in detecting equity mispricing and growth option of firms

Abstract

We compare two models that attempt to identify mispricing and growth option of firms: The residual income model (RIM) of Ohlson (1995) and a model developed by Rhodes-Kropf, Robinson, and Viswanathan (2005) (RKRV). For the sample of US publicly traded stocks for the period from 1971 to 2005, we find that we are able to calculate valuation measures for substantially more firm-years using RKRV than RIM. Sample firms for RKRV model tend to be smaller and have higher market-to-book ratio than sample firms using RIM model. More importantly, in a significant number of firm-years, these models disagree on whether a firm is misvalued or has high growth option considerably. We also find some differences between these two models in detecting misvaluation and/or growth option around events where extant literature suggests an important role for misvaluation or growth option, such as mergers and acquisitions, open market share repurchases, and stock splits.