How Good are Equity Valuation Models in Predicting Stock Prices?

Abstract

This paper aims to test the accuracy of three well-known equity valuation models for the period 1990 to 2006. This was done to a sample of German listed firms which diverge from the US market in accounting standards, market maturity and corporate governance culture (bank-based in contrast to the market-based US regime) as well as different market movements and trends which influence main input factors and estimations (e.g. market risk premium, inflation rate and GDP growth rate). To the best of our knowledge this is the first paper to address this issue for a sample of listed firms from the largest bank-based European economy.Using different accuracy measures such as absolute prediction error (average, median and central tendency) as well as multiple regression analysis the results show that dividend discount and abnormal earnings models ten to provide better accuracy than the free cash flow approach. Additionally, we find evidence of the importance in German accounting standards in the less accurate performance of the abnormal earnings model compared to previous studies due to the conservative accounting and the influence of hidden reserves. Finally, we did not find any significant valuation differences regarding the alternative values used for growth and discount rates.

Keywords: Accounting standards, Equity Valuation Models, Prediction Error, Value of Firm

JEL Classification: G3, G32