The pricing accuracy of alternative equity valuation models: Scandinavian evidence

Abstract

AbstractIn many decision contexts, there is a need for benchmark equity valuations, based on simplified modeling and publicly available information. Prior research on U.S. data however shows that the accuracy of such valuation models can be low and sensitive to the choice of model specifications and value driver predictions. In this paper, we test the applicability and pricing accuracy of three fundamental valuation (dividend discount, residual income, and abnormal earnings growth) models, all based on forecasts of company dividends, earnings, and/or equity book values. Extending prior research, we apply these models to Scandinavian firms with accounting data from the period 2005–2014, explicitly testing two approaches for the prediction of the value drivers—exogenously forecasted numbers versus projected historical numbers. Given access to the forecasted value drivers, the dividend discount model comes out as the most accurate valuation model. In particular, this holds in a comparison between the most parsimonious model specifications. The residual income valuation model generates the best pricing accuracy given the prediction of value drivers based on historical financial numbers. Notably, we observe pricing errors that in general are lower than what has been reported in prior U.S.‐based research for the dividend discount and the residual income valuation models. The pricing accuracy of the abnormal earnings growth models is surprisingly weak in the Scandinavian setting. However, these models improve somewhat after a couple of complexity adjustments, in particular with value driver predictions based on the projected history setting.