Firm Valuation Using the Edwards-Bell-Ohlson Framework
Posted: 28 Sep 1997
Date Written: May 1997
Abstract
This paper examines the determinants of price-to-earnings (PE) and price-to-book (PB) multiples with the aim of improving the selection of comparable firms used to estimate firm value. I then demonstrate that systematically selecting a subset of firms from within an industry, based on these determinants, results in a more comparable set of firms than the four digit sic industry grouping often used in practice. In the empirical tests, two set of artificial prices are constructed using a PE/PB valuation method. A benchmark artificial price is based on an industry price median multiple (PE or PB), consistent with results reported in Alford [1992]. The median PE (PB) is capitalized using the target firm's earnings (book value) to obtain an 'industry median price'. A second artificial price (an 'EBO median price') is formed by applying the median PE (PB) obtained from a selected subset of the target firm's industry to the target firm's earnings (book value).The selected subset of firms is composed firms from within the target firm's industry that have PE (PB) determinants most like the target firm. I document a substantial decrease in pricing errors (the difference between the artificial price and the market price) when using the determinants to select the set of comparable firms instead of the entire industry. Over a fifteen year period, in greater than 91% (98%) of the cases the mean (median) EBO pricing error is less than the mean (median) industry pricing error. Over 72% (68%) of the time that difference is statistically significant at less than the .05 level. My results suggest that using a more carefully grounded theoretical approach, even when using unsophisticated methods, yields a substantial improvement in valuation estimates. Implications for accounting research are discussed.
JEL Classification: G12, M41
Suggested Citation: Suggested Citation