Discussion Papers, Department of Business and Management Science, Norwegian School of Economics (NHH)
Jack D. Stecher
The Nonequivalence of the Earnings and Dividends Approaches to Equity Valuation
Abstract: Accounting theory treats a wide class of equity valuation
approaches as equivalent. For example, under clean surplus accounting, the
earnings approach is viewed as identical to the discounted dividends
approach. Empirical research, however, typically finds that the two
valuation approaches do not predict market prices equally well. This paper
offers a theoretical explanation for this apparent anomaly: expectations of
discounted infinite sums (incomes, cash flows, or dividends) are undefined
unless some restrictive probabilistic conditions hold. Without the usual
stationarity and ergodicity assumptions, it may still be possible to
estimate upper and lower bounds on such sums, but these bounds need not
coincide. In such a setting, earnings and discounted dividends yield
intervals of justifiable valuations, which intersect but need not coincide.
Depending on the extent to which a firm is held by insiders, differences in
the valuations that different formulae justify may not show up in market
prices. This provides an explanation for two additional empirical puzzles.
First, empirical studies detecting little incremental information in
dividends over earnings may be predisposed toward this finding. Second,
stronger apparent reactions to dividend omissions than to initiations may
be an illusion.
Keywords: Equity Valuation; Residual Income; Dividends; (follow links to similar papers)
JEL-Codes: C65; D82; G12; M41; (follow links to similar papers)
33 pages, March 3, 2006
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