Uncertainty in firm valuation and a cross-sectional misvaluation measure

Giulio Bottazzi, Francesco Cordoni, Giulia Livieri and Stefano Marmi

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: The degree of uncertainty associated with the value of a company plays a relevant role in valuation analysis. We propose an original and robust methodology for company market valuation, which replaces the traditional point estimate of the conventional Discounted Cash Flow model with a probability distribution of fair values that convey information about both the expected value of the company and its intrinsic uncertainty. Our methodology depends on two main ingredients: an econometric model for company revenues and a set of firm-specific balance sheet relations that are estimated using historical data. We explore the effectiveness and scope of our methodology through a series of statistical exercises on publicly traded U.S. companies. At the firm level, we show that the fair value distribution derived with our methodology constitutes a reliable predictor of the company’s future abnormal returns. At the market level, we show that a long-short valuation (LSV) factor, built using buy-sell recommendations based on the fair value distribution, contains information not accessible through the traditional market factors. The LSV factor significantly increases the explanatory and the predictive power of factor models estimated on portfolios and individual stock returns.

Keywords: Kalman filter; Stochastic discounted cash flow; valuation factor; valuation uncertainty (search for similar items in EconPapers)
JEL-codes: G11 G32 (search for similar items in EconPapers)
Pages: 31 pages
Date: 2023-03-01
New Economics Papers: this item is included in nep-cfn
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Published in Annals of Finance, 1, March, 2023, 19(1), pp. 63 - 93. ISSN: 1614-2446

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http://eprints.lse.ac.uk/118172/ Open access version. (application/pdf)

Related works:
Journal Article: Uncertainty in firm valuation and a cross-sectional misvaluation measure (2023)
Working Paper: Uncertainty in Firm Valuation and a Cross-Sectional Misvaluation Measure (2020)
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