Rating to Economic Profit: Valuation Properties, Implementation Issues, and the Justification of Target Prices
45 Pages Posted: 3 Jul 2019 Last revised: 8 Oct 2021
Date Written: October 8, 2021
Abstract
The primary objectives of this paper are to critically analyze and extend a fundamentals-based investment criterion (HSBC’s Rating to Economic Profit, REP) and to examine its ability to justify analysts’ target prices. This study justifies the use of REP as an investment appraisal technique, provides significant extensions of the basic formula, and discusses implementation issues. It also conducts a content analysis of selected analysts’ reports, which may serve as insightful cases facilitating the work of valuation educators and practitioners. We provide some descriptive evidence of the usefulness of accrual accounting numbers over dividends for valuation purposes. We also demonstrate that analysts may use REP to justify their target prices and explain concurrent stock market valuations. Finally, we offer estimates of the implied growth rates and the implied cost of equity by reverse-engineering the alternative formulas of REP. To the best of our knowledge, this is the first academic study that offers a comprehensive analysis of REP.
Keywords: Rating to Economic Profit (REP), Price-to-Book, Return on Equity, Financial Analysts, Equity Valuation, Target Prices.
JEL Classification: G32, M41
Suggested Citation: Suggested Citation