The Evaluation of Accounting-Based Valuation Models In the UK

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Abstract

This study provides two empirical studies in market-based accounting research. One study focuses on using out-of-sample valuation errors to evaluate various estimation approaches for firm-valuation models. The second empirical study uses portfolio analysis to evaluate an empirical accounting-based firm valuation model developed in the UK context.The first study uses out-of-sample valuation errors as an alternative metric capturing the effectiveness of various estimation approaches in generating reliable estimates of coefficients in accounting-based valuation models and, accordingly, less valuation bias and higher valuation accuracy. Valuation bias is expressed as the mean proportional valuation error, where estimated market value less the actually observed market value divided by the actual market value is the proportional valuation error, and valuation accuracy is measured by both the mean absolute and the mean squared proportional valuation error. We find that deflating the full equation including the constant term of the undeflated model and, hence, estimating without a constant term in the deflated model provides less bias and more accurate value estimates relative to including a constant term in the regression equation. Also estimating the valuation model on high- and low-intangible asset firms separately, instead of pooling the full sample for estimation, provides better performance in all cases. As expected, the results suggest that an extended model including the main accounting variables found to be associated with market value in the UK is better specified than a benchmark model, widely adopted in prior research, where market value is regressed on book value and earnings alone. Inclusion of ‘other information’ also seems to improve the performance of the models. However, there is no clear evidence that one particular deflator out of the five we investigate outperforms the others, although book value and opening and closing market value appear to generally perform better than sales and number of shares.The second empirical study tests for the existence of a “mispricing” effect associated with accounting-based valuation models in the UK. It investigates a specific firm valuation model where market value is expressed as a linear combination of book value, earnings, research and development expenditures, dividends, capital contributions, capital expenditures and other information. All these accounting variables have been found value-relevant in prior studies in the UK. Firms are ranked by in-sample proportional valuation errors. Results show that although firms in the higher rank deciles tend to have higher abnormal returns than firms in the lower rank deciles, the difference between the two extreme portfolios (or the hedge returns) is statistically insignificant. As a consequence, accounting-based valuation models do not seem to provide superior estimates of intrinsic value to market values. We can conclude that the UK stock market is semi-strong form efficient, in the sense that it does not appear to be possible to generate positive abnormal returns based upon publicly available accounting information embedded in the valuation models studied.

Keyword(s)

Accounting-based firm valuation model; Scale and scale effects

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