A Comparison of the Clean Surplus And Prospect Theory Valuation Models

Abstract

This study investigates the explanatory power of the clean surplus versus prospect theory valuation models. Literature argues that prospect theory and traditional capital market approaches are consistent from a theoretical perspective (Levy, De Giorgi and Hens 2012) . A comprehensive empirical analysis investigates the model valuations by examining: the pre/post 2008 crash, growth options, and size/risk attributes. In the process, the study does contribute knowledge about firm behavior pre and post the 2008 crash. As mentioned above, the study investigates the alternative firm models in a theoretical framework that incorporates growth options and assets-in-place. In so doing, the analyses find that growth options (e.g. research and development (R&D), and capital expenditures) model formulations have incremental explanatory power over the null hypothesis of not including a growth option. Thus, the study explores the decision-usefulness of the model alternatives to the extent that they impact upon firm increasing/decreasing returns to scale according to the log of R&D and capital expenditures. As part of the analysis, this study reports an interaction effect of R&D and capital expenditures. In summary, both clean surplus and prospect theory models capture value in all of these empirical dimensions. The clean surplus model appears to be a better predictor of firm value than prospect theory. To the authors’ knowledge, this the first empirical study to compare comprehensively the clean surplus formulation versus an alternative prospect theory approach, in particular, before and after the 2008 financial crisis.

Keywords: growth options; valuation model; size and PE sensitivity

JEL Classification: G01; G02; G12; M41