Terminal Value Techniques in Equity Valuation - Implications of the Steady State Assumption
AbstractThis paper examines the conditions necessary for calculating steady state terminal values in equity (company) valuation models. We make explicit use of the fact that a company's income statements and balance sheets can be modeled as a system of difference equations. From these difference equations, we derive conditions for steady state. The conditions ensure that the company remains qualitatively similar year by year after the valuation horizon and that it has a stable development of earnings, free cash flows, dividends and residual income. We show how steady state condition violations cause internal inconsistencies in valuation models and how this can have a substantial impact on the value estimates. Steady state is further a necessary condition for a free cash flow valuation, a dividend valuation and a residual income valuation to yield identical results when terminal values are used. The parameters of the model are common accounting and control concepts, and the derived conditions have accounting meaning, linking stock variables in the balance sheet with the flow variables in (and related to) the income statement.
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Bibliographic InfoPaper provided by Stockholm School of Economics in its series Working Paper Series in Business Administration with number 2000:7.
Length: 26 pages
Date of creation: 30 Jun 2000
Date of revision:
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equity valuation; terminal value; financial statement analysis;
Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
- M49 - Business Administration and Business Economics; Marketing; Accounting - - Accounting - - - Other
This paper has been announced in the following NEP Reports:
- NEP-ALL-2000-07-27 (All new papers)
- NEP-CFN-2000-07-27 (Corporate Finance)
- NEP-FIN-2000-07-27 (Finance)
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