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Terminal Value Techniques in Equity Valuation - Implications of the Steady State Assumption

Listed author(s):
  • Levin, Joakim

    (Dept. of Business Administration, Stockholm School of Economics)

  • Olsson, Per M.


    (School of Business, University of Wisconsin-Madison)

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    This 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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    Paper provided by Stockholm School of Economics in its series SSE/EFI Working Paper Series in Business Administration with number 2000:7.

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    Length: 26 pages
    Date of creation: 30 Jun 2000
    Handle: RePEc:hhb:hastba:2000_007
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