Equity Valuation Employing the Ideal versus Ad Hoc Terminal Value Expressions

Recently, Penman and Sougiannis (1998) and Francis, Olsson, and Oswald (2000) compared the bias and accuracy of the discounted cash flow model (DCF) and Edwards†Bell†Ohlson residual income model (RIM) in explaining the relation between value estimates and observed stock prices. Both studies report that, with non†price†based terminal values, RIM outperforms DCF. Our first research objective is to explore the question whether, over a five†year valuation horizon, DCF and RIM are empirically equivalent when Penman's (1997) theoretically “ideal†terminal value expressions are employed in each model. Using Value Line terminal stock price forecasts at the horizon to proxy for such values, we find empirical support for the prediction of equivalence between these valuation models. Thus, the apparent superiority of RIM does not hold in a level playing field comparison. Our second research objective is to demonstrate that, within each class of the DCF and RIM valuation models, the model that employs Value Line forecasted price in the terminal value expression generates the lowest prediction errors, compared with models that employ non†price†based terminal values under arbitrary growth assumptions. The results indicate that, for both DCF and RIM, price†based valuation models outperform the corresponding non†price†based models by a wide margin. These results imply that researchers should exercise care in interpreting findings from models using ad hoc terminal value expressions.