A Comparison of Dividend, Cash Flow, and Earnings Approaches to Equity Valuation*

Stephen H. Penman and Theodore Sougiannis

Contemporary Accounting Research, 1998, vol. 15, issue 3, 343-383

Abstract: Standard formulas for valuing the equity of going concerns require forecasting payoffs to infinity but practical analysis requires that payoffs be forecasted over finite horizons. This truncation inevitably involves often†troublesome terminal value calculations. This paper contrasts dividend discount techniques, discounted cash flow analysis, and techniques based on accrual earnings when each is applied with finite†horizon forecasts. Valuations based on average ex post payoffs over various horizons, with and without terminal value calculations, are compared with ex ante market prices to discover the error introduced by each technique in truncating the horizon. Valuation errors are lower using accrual earnings techniques rather than cash flow and dividend discounting techniques. The accounting features that make a given technique less than ideal for finite horizon analysis are also detailed. Conditions where a given technique requires particularly long forecasting horizons are identified and the performance of the alternative techniques under those conditions is examined.

Date: 1998
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https://doi.org/10.1111/j.1911-3846.1998.tb00564.x

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Persistent link: https://EconPapers.repec.org/RePEc:wly:coacre:v:15:y:1998:i:3:p:343-383

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