Conservatism in Corporate Valuation
Using a CCAPM based risk adjustment model, consistent with general asset pricing theory, I perform corporate valuations of a large sample of stocks listed on NYSE, AMEX and NASDAQ. The model is different from the standard CAPM model in the sense that it discounts forecasted residual income for risk in the numerator rather than trough the cost of equity, in the denominator. Further, the risk adjustment is based on assumptions about the time series properties of residual income return and consumption rather than historical returns. I compare the pricing performance of the model with the standard CAPM based valuation model, both considering the absolute valuation errors and an investment setting where simple investment strategies are made based on the results of the respective models. The CCAPM model performs substantially better than the CAPM based model when comparing absolute valuation errors. Both models are able to explain abnormal returns impressively well, when constructing investment strategies, but also in this setting the CCAPM model outperforms the CAPM model in most dimensions. I further show that the standard CAPM and the Fama-French 3 factor based approaches to risk adjustment substantially overestimate the cost of risk. This "error" more than offsets yet another "error", committed when using analyst's forecasts of long-term growth which are 3-4 times higher than what can be considered reasonable. Using the CCAPM approach to valuation, the results imply that investors are very conservative in their valuation of long-term value generation and very conservative in risk adjusting future value generation.
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