The Valuation Properties of the Rating to Economic Profit

Abstract

The primary objectives of this paper are to critically analyze and extend a fundamentals-based investment criterion (HSBC’s Rating to Economic Profit – REP) and to examine its ability to justify analysts’ target prices. Although variations of this model are used extensively in practice, REP has mostly been ignored by academics. This study justifies the use of REP as an investment appraisal technique, provides significant extensions of the basic formula, and discusses implementation issues. It also conducts a content analysis of selected analysts’ reports, which may serve as insightful cases facilitating the work of valuation educators and practitioners. The authors provide some descriptive evidence of the usefulness of accrual accounting numbers over dividends for valuation purposes. Finally, the authors empirically show that analysts may use REP to justify their target prices, and offer estimates of the implied growth rates by reverse-engineering the growth-adjusted formula of REP. This paper should be of interest to empiricists in the area of market-based accounting research, valuation educators, and financial analysts. To the best of the authors’ knowledge, this is the first academic study that offers a comprehensive analysis of REP.