Extended Dividend, Cash Flow and Residual Income Valuation Models -Accounting for Deviations from Ideal Conditions

Standard equity valuation approaches (i.e., DDM, RIM, and DCF model) are derived under theassumption of ideal conditions, such as infinite payoffs and clean surplus accounting. Becausethese conditions are hardly ever met, we extend the standard approaches, based on thefundamental principle of financial statement articulation. The extended models are then testedempirically by employing two sets of forecasts: (1) analyst forecasts provided by Value Line and(2) forecasts generated by cross-sectional regression models. The main result is that our extendedmodels yield considerably smaller valuation errors. Moreover, by construction, identical valueestimates are obtained across the extended models. By reestablishing empirical equivalence undernon-ideal conditions, our approach provides a benchmark that enables us to quantify the errorsresulting from individual deviations from ideal conditions, and thus, to analyze the robustness ofthe standard approaches. Finally, by providing a level playing field for the different valuationapproaches, our findings have implications for other empirical settings, for example, estimatingthe implied cost of capital.