Valuation Accuracy and Infinity Horizon Forecast: Empirical Evidence from Europe

Abstract

AbstractThis paper focuses on the assumptions of infinite‐horizon forecasting in the field of firm valuation. The estimate of long‐run continuing values is based on the hypothesis that companies should have reached the steady state at the end of the period of explicit forecasts. It is argued that the equivalence between cash accounting and accrual accounting is the way of verifying the steady‐state assumption, defined as the state when a firm earns exactly its cost of capital, i.e., what we would expect in pure‐competition settings. From this definition, we derive that the “ideal” growth rate to use in steady state is equal to the reinvestment rate times Weighted Average Cost of Capital. To validate our approach, we collect a sample of 784 analyst valuations and compare how the implied target prices deviate from what the target prices would have been using the “ideal” steady‐state growth rates. Using Logit and Cox regression models, we find that this deviation has predictive value over the probability that actual market price reaches the target price over the following 12‐month period—the smaller the deviation the greater is the likelihood that the market price reaches the target price.