International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 7 (2007)

© EuroJournals Publishing, Inc. 2007
http://www.eurojournals.com/finance.htm

Empirical Evidence on Retail Firms’ Equity Valuation Models

Anastasia Vardavaki
13 Epidavrou str., Halandri, 152 33 Athens, Greece
E-mail: anastasia_vardavaki@yahoo.gr

John Mylonakis
10 Nikiforou str., Glyfada, 166 75 Athens, Greece
E-mail: imylonakis@panafonet.r

Abstract

This paper presents the theoretical framework for the process of equity valuation
and investigates the relative explanatory power of alternative linear equity valuation
models when applied to firms in the UK food and drug retail sector. Due to practical
difficulties in applying all valuation models, the empirical tests for the equity valuation are
based on a) the asset-based model, which contains only book value as an independent
variable; b) the earnings-based model, and c) the combined model, which contains both
book value and current earnings or abnormal earnings as value-relevant variables. The
results of the empirical analysis support precious studies that the combined valuation model
is more informative by providing better and more accurate estimations of equity market
values. This can be explained by the fact that this model incorporates both the economics
and the accounting characteristics of the examined firms.

Key words: Equity Valuation Models, Asset-Bards Model, Discounted Cash Flow Model,
Discounted Residual Income, Equity Market Value
JEL classification: G 380

1. Introduction
Fundamental analysis entails the use of information in current and past financial statements, in
conjunction with industry and macroeconomic variables in order to determine the firm’s intrinsic
value. To a fundamental analyst, the market equity price tends to move towards the fundamental-
intrinsic value. A difference between the current and the intrinsic value is an indicator of the expected
excess rewards for investing in the security. A large body of research demonstrates that economically
significant abnormal returns spread over several years can be obtained by implementing fundamental
analysis trading strategies.
Equity valuation itself constitutes a fairly significant issue that has generated the intense
interest of various economic and financial analysts. Valuation research has emerged as a central theme
in the accounting research of the 1990s. This literature has had a substantial impact on the research
agendas of academics and on the day-to-day work of practitioners. According to the ‘Efficient Market
Hypothesis’, as defined by Fama (1970, 1991), security prices fully reflect all available information.
Whether security markets are informationally efficient is of great interest to investors, shareholders,
managers, lenders, standard setters and other market participants who care about intrinsic value of the
firm.
105 International Research Journal of Finance and Economics - Issue 7 (2007)

There are several important valuation models that are applied for the purpose of determining
the firm’s fundamental value. In an ideal world, where markets are perfect and efficient, the intrinsic
firm value equals the equity book value. However, in the real world, the book value of shareholder
equity is generally lower than the market equity value. That is, the book-to-market ratio is less than the
unity.
The purpose of this paper is to present the theoretical framework of equity valuation models
(Asset-Based, Discounted Cash Flow and Discounted Residual Income) and to empirically test these
valuation models in a sample of UK food-drug retail companies, including a discussion of diagnostic
tests and some important econometric issues.

2. Theoretical framework on Equity Valuation Models

Valuation is the process of forecasting the present value of the expected payoffs to shareholders and of
converting this forecast into one number that corresponds to the fundamental-intrinsic firm value. Lee
(1999) argues that valuation models are merely ‘pro forma accounting systems’ that constitute the
vehicles for articulating the assessment of future events typically in terms of accounting constructs.
According to Barker (2001), a good understanding of valuation methods requires two main things. The
first is an analytical review of the models, identifying their relationship and exposing their
assumptions. The second is an evaluation of the data that are available for use of these models.
Therefore, there is a significant relationship between the choice of valuation models and the available
data.

2.1 Valuation Models Description

There are some important theoretical valuation models which can be applied to equity valuation. In this
section the three types of valuation models most widely used are described:
A. the Asset-Based Valuation Model,
B. the Discounted Cash Flow Models which consist of three sub categories, the Free Cash Flow,
the Dividend-Based and the Earnings-Based Model and finally
C. the Discounted Residual Income or Edwards-Bell-Ohlson (EBO) Model
A. Asset Based Valuation Model assigns a value to the firm based on the fair value of individual
component assets. Liabilities (also at fair prices) are deducted to arrive at the value of the firm’s equity.
This model can be applied when balance sheets are perfect, that is, the assets and liabilities are
recorded at fair market value. Since they are priced efficiently in the market, they will earn at their cost
of capital. In this case, intrinsic value equals book value and the expected future residual income is
zero. Residual income for period t is defined as the comprehensive earnings available to common
equity for the period less a charge against the earnings for the book value at the beginning of the period
Bt-1, earning at the cost of capital. Therefore, when there is neither unrecorded goodwill nor omitted
value, the asset-based valuation model defines the firm value Vt * as the sum of fair values of net
tangible and intangible assets:
∞
Vt * = ∑ fvi
i =1
This model is most applicable to value net financial obligations which are recorded at market
value but not to value net operating assets since some of them are measured at depreciated historical
cost (such as property, plant, equipment) and some at zero value (omitted knowledge assets and other
intangibles). Therefore, this model can be used to value firms with large fixed assets and firms
applying simple technology.
B. Discounted Valuation Models assign a value to the firm that equals the present value of expected
future accounting measures, based on all currently available information. The parameters that make up
International Research Journal of Finance and Economics - Issue 7 (2007) 106

Discounted Valuation Models are related to risk (the required rate of return) and the return itself ( CFt +i
which are the cash flows), as:
∞
E (CFt +i )
Vt * ≡ ∑ t
i =1 (1 + re )
i

These models use three alternative cash flow measures: a) free cash flows, b) dividends and c)
accounting earnings. Under the assumption of perfect markets, these models give the same results as
the asset-based valuation model.
a) Free Cash Flow Model assumes that the firm’s value equals the present value of cash flows
from all the projects in its operations. Free cash flow is the difference between the cash flow from
operations and cash investment. It is the cash available to debt and equity holders after investment. The
Free Cash Flow Model (FCF) is specified by Copeland, Koller and Murrin (2000) as:
∞
E ( FCFt )
Vt * ≡ ∑ t + ECMS t − Dt − PS t
i =1 (1 + r f )
i

where Vt * the market value of equity at time t, r f the weighted average cost of capital, ECMSt the
excess cash and marketable securities, Dt the market value of debt and PSt the market value of
preferred stock at time t.
b) Dividend Discount Model assumes that a stock's fundamental equity value can be defined as
the present value of its expected future dividends based on all currently available information.
∞
E (D )
Vt * ≡ ∑ t t + i i
i =1 (1 + re )

In this definition, Vt * is the stock's fundamental value at time t, Et ( Dt + i ) are the expected future
dividends for period t+i conditional on information available at time t, and re is the cost of equity
capital based on the information set at time t. This definition assumes a flat term-structure of discount
rates.
c) Under Earnings-Based Valuation Approach, a firm’s equity value can be expressed as the
sum of the expected earnings, discounted at an appropriate risk-adjusted discount rate:
∞
E (X )
Vt * ≡ ∑ t t + ii
i =1 (1 + re )

In the case that the expected future annual income level Et (X ) is constant, the ‘capitalization
of earnings’ approach can be applied:
E (X )
Vt * ≡ t *
r
where r* is the risk adjusted capitalization rate. Unlike the asset-based approach, this model can
capture unrecorded goodwill, that is, the difference between the book value and market value of the
firm’s assets. The earnings-based model is often applied to firms such as technology intensive firms
(computer firms, telecommunication firms) that have considerable unrecorded intangible assets and
high expected future cash flows.
C. Discounted- Residual Income Model, sometimes referred to as Edwards-Bell-Ohlson (EBO), is
generally considered to be the most reliable model for equity valuation. It provides a way of thinking
about value generation in the business. It is an accrual accounting model where the central concept is
the residual income, a measure of accounting income in excess of a normal/required return on capital
employed. As far as the model of Ohlson (1995), the parameters that make up the Discounted Residual
Income Model are:
∞
E [ NI t + i − (re * Bt + i −1 )] ∞
Et [( ROEt +i − re ) * Bt + i −1 ]
Vt* ≡ Bt + ∑ t ≡ Bt + ∑
i =1 (1 + re ) i
i =1 (1 + re ) i
107 International Research Journal of Finance and Economics - Issue 7 (2007)

where Bt is the book value at time t, Bt +i −1 is the beginning-of-year book value at t, Et[.] is expectation
based on information available at time t, NIt+i is the Net Income for period t+i, re is the cost of equity
capital and ROEt+i is the after-tax return on book equity for period t+i.
This is the Residual Income Model (RIM) which shows that equity value can be split into two
components: an accounting measure of the capital invested (Bt), and a measure of the present value of
future residual income, defined as present value of future discounted cash flows not captured by the
current book value. If a firm earns future accounting income at a rate exactly equal to its cost of equity
capital, then the present value of future residual income is zero, and Vt=Bt. In other words, firms that
neither create nor destroy wealth relative to their accounting-based shareholders' equity, will be worth
only their current book value. However, firms with expected ROEs higher (lower) than re will have
values greater (lower) than their book values. Therefore, the RIM is a combination between asset-based
valuation model for firm’s financial activities and earnings-based model for operating activities. Since
it incorporates firm’s stock and flow components, it is most applicable to companies with high fixed
and intangible assets and whose values are generated by both assets and future stream of earnings.

2.2 Comparison of Valuation Models

Several authors have shown that there is a theoretical equivalence between the free cash flow model,
the dividend discount model and the residual income model. Plenborg (2000) states that these valuation
techniques should give consistent and identical estimates of intrinsic firm value, provided that all the
forecasts of the different items are consistent with each other within a clean surplus relationship and all
the assumptions are identical. Moreover, for all sets of accounting rules, these models produce the
same valuation when infinite-horizon forecasts are used. Thus, the dividend, cash flow and residual
income approaches are equivalent when the respective payoffs are predicted to infinity.
However, these zero-error conditions are very restrictive. In practice, forecasts are made over
finite horizons so different accounting principles yield different estimates with finite-horizon forecasts.
For this reason, steady state terminal values, which usually have considerable weight in equity
valuation, are calculated in practice to correct for error introduced by the truncated forecast horizon
and such calculations are necessary for all clean-surplus accounting methods. Specifically, Levin and
Olsson (2000) argue that the steady state conditions ensure that the company’s forecasted performance
remains stable after the valuation horizon and that its expected development, as described by its
parameters, holds indefinitely. They also claim that steady state is a necessary condition for the three
models to yield identical results when terminal values are used. Therefore, any steady state condition
violation can cause internal inconsistencies in valuation models and thus have a significant effect on
the equity value estimates.
Furthermore, according to Olsson (1998), valuation models give different value estimates when
different simplifying assumptions are introduced, since these assumptions introduce bias in the firm
value estimates. At this point it should be mentioned that Penman and Sougiannis (1998) and Francis,
Olsson and Oswald (2000) do not take into account the fact that the same assumptions must be applied
to the models so that they yield identical valuations. The use of simplifying assumptions in both studies
makes the link between the forecasted financial statements and the input in the different valuation
approaches most likely inconsistent. Based on these distinct assumptions, both studies suggest that
RIM is superior to the other models. Therefore, these two studies indicate that if the internal coherence
between the three valuation models is violated, the RIM yields more accurate firm value estimates than
the FCF or the DDM, most likely due to the use of different assumptions.
Nevertheless in practice, there are a number of potential advantages of the Residual Income
(accounting-based) approach to valuation:
i) The cash flow-based approaches measure the expected distribution of wealth by the business to
its investors. In contrast, accounting-based models provide a way of thinking about a business
and about value generation in the business. It focuses on profitability of investment (reflected by
the return on common equity) and growth in investment (given by the increase in book equity
International Research Journal of Finance and Economics - Issue 7 (2007) 108

value), factors that drive value. Therefore, this model directs management to add value to the
business by increasing residual earnings, which, in turn, requires increasing ROCE and growing
investments.
ii) The RI shows that the estimate of intrinsic value can be split into net assets in place and ‘super
profits’. Expectations of future abnormal earnings can be driven by beliefs concerning the nature
and likely life span of the firm’s competitive advantage. Thus, RI model provides a mechanism
for the direct incorporation of beliefs about competitive advantage.
iii) In contrast to cash flow models, the RIM treats investments as part of book value and states that
investments generate zero residual earnings and thus have no effect on value calculated.
Moreover, residual income is not affected by dividends, share issues and share repurchases, so
using the RIM yields valuations that are not sensitive to these value irrelevant transactions with
shareholders when there are no market imperfections.
iv) The cash flow-based models can lead to inaccurate estimates of intrinsic value, since they are
wholly dependent upon forecasts that are uncertain. In contrast, because a significant proportion
of the estimate of the fundamental value given by the RI model is embedded within the
observable accounting book value, this approach is only partially dependent upon forecasts.
Thus, there is less scope for error in the estimate arising from error in the forecasts.
v) Unlike the cash flow models that do not measure value added in the short-run, the residual
income model uses accrual accounting which captures value ahead of cash flows and matches
value added to value given up. Furthermore, it can be used with a wide variety of accounting
principles as long as income is measured on a comprehensive basis. The application of forecast-
based models tends to rely upon explicit forecasts up to a medium-term horizon, plus an estimate
of the value of the post-horizon flows, which represents the major part of the intrinsic value
estimate. These models are very sensitive to terminal values, which often account for more than
50% of the valuation of a firm. In contrast, the proportion of the intrinsic value estimate that
relies on forecasts is lower for the RI model than for cash flow models due to the inclusion of
book value.

3. Research Methodology
The purpose of the study is to present some valuation models applicable to the UK food retail sector
and test which model explains the largest proportion of the cross-sectional variation in equity values.
Tests include the estimation of linear regressions with dependent variable the firm’s equity market
value and several components of financial statements as the independent variables. The method used
for estimation of the valuation models is the ordinary least square (OLS), which minimizes the residual
sum of squares, that is, the difference between the actual and the estimated values of the dependent
variable. The reason for using this method is that there is a linear relationship between the equity
market value and the (current or beginning of year) book value or/and current earnings or abnormal
earnings.

3.1 Valuation Models selected

At this point it should be mentioned that, since we can not have access to forecasts of free cash flow,
dividends and earnings, it is impossible to apply the traditional cash flow and residual income models
to the case study of UK food retail sector. The empirical tests are conducted with the use of models that
do not require forecasts but estimate the intrinsic firm value as a weighted average of current book
value and current accounting earnings. Thus, the estimated valuation models will be:
A. the asset-based model,
B. the earnings-based model, as well as,
C. the basic combined model and the combined abnormal valuation model
109 International Research Journal of Finance and Economics - Issue 7 (2007)

A. The Asset-Based valuation model tests the proportion of the equity value explained only by the
equity book value. The simple version of the model is:
MVt = α 0t + α 1t Bt + ε t
where MVt is the market value of equity and Bt the current equity book value for the firms in the UK
food and drug retail sector during the period from 1998 to 2001. Splitting the book equity value into its
various components we can derive a more complicated current asset-based model:
MVt = α 0t + α 1t FAt −1 + α 2t ∆FAt + α 3t I t + α 4t NDt + α 5t NOAt + ε t
This separation seems reasonable since the various components of the balance sheet are valued
under different pricing rules. FAt −1 reflects the net tangible and intangible assets, ∆FAt is the net
investments in net tangible and intangible assets during the current period, I t is the current fixed asset
investments, NDt is the net debt and NOAt is the net other assets which represent mainly operating
assets.
According to Collins et al. (1999), the book value of equity for the previous year can used as a
proxy for the present value of expected future normal earnings, thus can contribute to the explanation
of variation in equity values. For this reason, we also consider another asset-based valuation model
with independent variable the equity book value at the end of the previous accounting year t-1, Bt −1 :
MVt = α 0t + α 1t Bt −1 + ε t
Again, splitting the previous year’s equity book value into its components appears that:
MVt = α 0t + α 1t FAt −1 + α 2t I t −1 + α 3t NDt −1 + α 4t NOAt −1 + ε t
This model has fewer independent variables than the asset model including components of
current book value. These variables are all taken from the balance sheet of the previous accounting
year t-1.
According to Dechow et al. (1999), all these asset-based valuation models assume that
expectations of future abnormal earnings are based solely on information in current abnormal earnings
and abnormal earnings are purely transitory. Consequently, expected future abnormal earnings are zero
and price is equal to book value. This restricted version of Ohlson’s model corresponds to valuation
models in which accounting earnings are assumed to measure ‘value creation’ and thus they regress
market values only on book values.
B. The Earnings-Based Valuation Model alone can explain the market equity value of firms in the
UK food retail sector. More specifically:
MVt = α 0t + α1t EBITDAt + ε t
where the market value of equity ( MVt ) is assumed to be a linear function of a constant term α 0t , and
EBITDAt which is defined as earnings before interest, tax, depreciation and amortization (which are
charged according to the above-mentioned rules).
A model including separate components of EBITDA is estimated but it is found that it does not
increase the overall explanatory power and so we do not include it in our results. This model, also,
assumes that expectations of future abnormal earnings (AE) are based on current AE but in contrast to
the asset-based models, it assumes AE persist indefinitely. These assumptions imply that expected AE
equal current AE and price equals current earnings capitalized in perpetuity. Therefore, this special
case of Ohlson’s model corresponds closely to the popular earnings capitalization valuation model in
which earnings are assumed to follow a random walk process and book value does not enter the
equation. The above equation reflects the earnings-based model.
C. Combined Valuation Models and Combined Abnormal Valuation Models
Combined Valuation Models
These empirical models approach the spirit of the residual income model, since they assume that
including both book value and earnings helps explain better and more accurately the cross-sectional
International Research Journal of Finance and Economics - Issue 7 (2007) 110

variation in equity values. Therefore, combining the earnings-based model with each of the four asset-
based models, we estimate annual regressions of the following forms:
MVt = α 0t + α 1t Bt + α 2t EBITDAt + ε t
MVt = α 0t + α 1t FAt −1 + α 2t ∆FAt + α 3t I t + α 4t NDt + α 5t NOAt + α 6t EBITDAt + ε t
MVt = α 0t + α 1t Bt −1 + α 2t EBITDAt + ε t
MVt = α 0t + α 1t FAt −1 + α 2t I t −1 + α 3t NDt −1 + α 4t NOAt −1 + α 5t EBITDAt + ε t
Note that in all the above models the unspecified ‘other information’ variable v in the Ohlson’s
model is deleted and replaced with an intercept term and an error term. The intercept allows for
nonzero mean pricing effects of the omitted other information, which becomes part of the error term.
Collins et al. (1999) give the intuition for using beginning-of-year as opposed to end-of-year book
value in the third equation. By the clean surplus relation, Bt = Bt-1+ NIt - Dt, current earnings are
included as part of end-of-year book value. Hence, if Bt were in the model, the coefficient on earnings
would capture the direct effect of earnings on stock prices and the coefficient on end-of-year book
value would capture the indirect effect of earnings through its effect on Bt. Thus, by using Bt-1, the
coefficient on earnings reflects the full pricing effect of current earnings while the coefficient on Bt-1 is
not contaminated with the effects of current earnings.
Combined Abnormal Valuation Models
This empirical model tries to capture more accurately the spirit of Residual Income Model, by
substituting abnormal earnings for earnings in the above models. We consider only the models that
include the whole book value, rather than the separate components since the results are not
significantly different. Thus, the two examined models are:
MVt = α 0t + α 1t Bt + α 2t AEt + ε t
MVt = α 0t + α 1t Bt −1 + α 2t AEt + ε t
AEt = NIt - re* Bt-1,
where Bt-1 is the beginning-of-year book value and net income, NIt, is earnings from ordinary activities.
There are some studies that use instead of net income the income to ordinary shareholders before
extraordinary items, discontinued operations and tax adjusted unusual items. Although defining NIt in
this way violates the clean surplus assumption of Ohlson (1995), Barth et al. (1999) claim that it
eliminates potentially confounding effects of large one-time items, that is, it controls for non-recurring
items in earnings. However, since in the food retail sector the effects of extraordinary items and
discontinued operations are minor, we calculate abnormal earnings on the basis of net income. The
equity cost of capital is given by the Capital Asset Pricing Model:
re = Rf +beta (mrp)
As in Abukari et al. (2000), we use Rf the 90-day T-bill rate and the market risk premium (mrp)
the historical average of 6% used in other studies. Beta is the historical company’s stock beta for each
accounting year. If the Ohlson model holds, the coefficients on equity book value in the above
equations should equal one. Note that intercepts are included to allow for the valuation effects of other
information.
According to Dechow et al. (1999), in contrast to asset-based and earnings-based models, this
model assumes that expectations of future AE are based solely on current AE and that AE mean revert
at their unconditional historical rate. Expected AE equal current AE multiplied by the persistence
parameter. Price is a linear function of book value and current AE. The relative weight on book value
(AE) is decreasing (increasing) in the persistence parameter.

3.2 Sample selection and data gathering and descriptive statistics

This study examines the ten biggest firms in the UK Food and Drug Retail Sector, in terms of total
sales-turnover. Only quoted public firms are taken into account, since privately owned or unquoted
have no reported market value. Of these firms, the first six are much larger than the others and
constitute almost all the leading firms in the general UK retail sector (except for Asda which was
111 International Research Journal of Finance and Economics - Issue 7 (2007)

acquired by Walmart). Table 1 presents the list of firms included in the sample along with their total
turnover.

Table 1: Food and Drug retailers' turnover (£mn)

1997 1998 1999 2000 2001

Tesco (UK) (Feb) 13,887 16,452 17,158 18,796 20,988
Sainsbury's (Mar) 13,395 14,500 16,433 16,271 17,244
Safeway (Mar) 6,590 6,979 7,511 7,659 8,151
Somerfield (Apr) 3,200 3,484 5,898 5,266 4,612
The Big Good Food (Mar) 1,427 1,566 1,742 1,918 5,279
Wm Morrison (Jan) 2,176 2,297 2,534 2,970 3,500
T & S Stores (Jan) 550 649 774 886 933
Alldays (Oct) 637 698 572 538 525
Budgens (April) 320 362 411 421 445
Greggs (Dec) 266 291 309 339 377
Source: Audited Financial Statements

The accounting information for the examined firms was collected from the Annual Reports and
Accounts for four accounting years, 1998 to 2001. The operating and financial reviews along with the
notes to the financial statements for each firm contributed to the accurate extraction of accounting
information. The equity market values of the firms were obtained from Datastream which contains
daily data. The market value used in each annual regression is the equity market value three months
after the close of the accounting year. This procedure is applied to other similar studies, e.g the study
of Abukari et al. (2000). The 90-day T-bill rates and the firms’ betas, derived also from Datastream, are
monthly data and correspond to the risk-free rate and historical betas three months after the close of the
accounting year.

4. Research Results
The outputs from the estimation of the valuation models give the magnitude of the estimated
coefficients along with their t-statistics and the corresponding p-values. The p-values, which are known
as the exact levels of significance of the test, reflect the probability of obtaining a value of the test
greater or equal to that obtained in the sample, under the assumption of normally distributed residuals.
Furthermore, the estimation outputs give the values of adjusted R2 statistic which measure the
proportion of total variation of market value explained by each model. The F-statistic tests the overall
significance of the regression and its null hypothesis is that all the coefficients except the intercept are
jointly equal to zero. Finally, the Akaike information criterion (AIC) and the Schwarz criterion (SC)
are guides to the selection of the number of parameters in a model and generally lead to the choice of
parsimonious econometric models.
The correlation matrixes of the independent variables for each year are presented in table 2
(Appendix). The diagnostic tests that ensure that the examined models are correctly specified are
presented in table 3 (Appendix) .
A test for normality is carried out to examine whether the computed values of skewness and
kurtosis of the residuals depart from 0 and 3 respectively. The Jarque-Bera (JB) statistic tests the null
hypothesis that the residuals are normally distributed. A significant JB test may indicate the presence
of outlier observations or of heteroscedasticity. Results suggest that the residuals from all the estimated
models are normally distributed, since the JB statistic is insignificant and so the null can not be
rejected.
The heteroscedasticity in the residuals can be tested with two different tests. First, the ARCH
LM test is used when there is evidence of conditional heteroscedasticity in the residuals. Regressing
the squared residuals on a constant term and p lagged values it tests whether the coefficients of the lags
are statistically significant. The results show that the test statistic is insignificant for all the regressions,
International Research Journal of Finance and Economics - Issue 7 (2007) 112

apart from the current asset-based model (Bt), thus the null that residuals are conditionally
homoscedastic can not be rejected. Second, the White Heteroscedastic test is used when the form of
heteroscedasticity is not known. Values reported suggest that the X2 statistic does not exceed the
corresponding critical values for all the models, except again for the current asset-based model (Bt),
thus the null that states that the residuals are homoscedastic can not be rejected. Therefore, there is no
need to correct for heteroscedasticity by estimating the models with the generalized OLS.
Serial correlation in the residuals is tested with the Lagrange Multiplier Method. The LM
statistic is calculated from an auxiliary regression of the ε t on the q lagged values and all the other
original explanatory variables. It tests whether the coefficients of the lags are statistically significant.
The results show that the test statistic is insignificant for all the models so the hypothesis of no serial
correlation can not be rejected implying that residuals are not correlated over time.
Moreover, the empirical analysis is based on undeflated variables, while many previous studies
use deflated variables or variables on per share or per firm basis. The reason for not using deflated
variables is that, as Rees (1999) states, the results in deflated models are sensitive to the choice of
deflator that may cause possible biases. In addition, Rees (1997) claims that it is difficult to interpret
the results of the per share specification when a substantial portion of the value of the firm is explained
by the intercept term normally included in per share models.

4.1 Empirical Results by Valuation Model

4.1.1 Basic Asset-Based Models
The estimation output of the current asset-based model (Bt) shows that the model has a very high
explanatory power (R2= 0.8685 on average). This suggests that current book value is an important
variable in explaining the market equity values. In fact, the coefficient of Bt is statistically significant
in all the accounting years.
This result is, also, highlighted when the model consists of the components of current book
value since it has higher explanatory power (adjusted R2=0.9583 on average) than the previous
estimated model. Specifically, in 1998 there are three statistically significant coefficients (FAt-1, It and
NDt) at the 5% significance level. In 1999 and 2000 the significant coefficients are two: ∆FAt and NDt,
∆FAt and NOAt respectively. In contrast, in 2001 FAt-1 is the only significant variable. Therefore, it can
be argued that the separate balance sheet components offer additional explanatory power compared to
the initial model.
The results from the asset-based model including Bt-1 show that the value of R2 is again high
(0.857 on average), implying that the beginning of year book value explains the equity valuation of
firms in the UK food retail sector to a great extent. The coefficient of this single independent variable
is statistically significant for all years and the F-statistic is also very high. Since the value of R2 is
lower than that of the first model, it can be argued that the beginning-of-year book value does not give
better results, contrary to Collins et al. who claim that Bt-1 is more accurate variable because it is not
contaminated with the effects of current period earnings.
The model which contains the components of balance sheet in the period t-1, also has high
explanatory power (R2=0.953 on average). The increase in the R2 is reasonable since more variables
are included in the model. Specifically, in 1998 there are three significant variables (FAt-1, It-1 and NDt-
1) while in 1999 and 2001 there is only one (It and FAt respectively). In contrast, the annual regression
of 2000 consists of variables that are all individually significant. Thus, the split of book equity value
into components adds incremental explanatory power for equity valuation. The principal component
analysis gives a value of R2 very close to that of the original model so multicolinearity does not cause
significant problems in the interpretation of results.
Overall, it could be claimed that there is no much difference in the results between the models
using the current or the beginning-of-year book value. However, the asset-based models that use
components of either Bt or Bt-1 have greater explanatory power.
113 International Research Journal of Finance and Economics - Issue 7 (2007)

4.1.2 Earnings-Based Valuation Model

The estimation output for the EBITDA model shows that this model has lower value of R2 (0.759 on
average) than the asset-based models considered above. In particular, 1998 the adjusted R2 takes its
lowest value (0.50). However, there is a significant increase in the value of R2 across time, which may
imply an increase in the persistence of earnings. The coefficient of EBITDAt is statistically significant
in all accounting years. Nevertheless the average value of adjusted R2 suggests that EBITDAt alone
explains a relatively small proportion of the total variation of equity values. Thus, profit and loss
accounting numbers individually do not provide sufficient explanatory power for equity valuation of
firms in the UK food retail sector.

4.1.3 Combined Valuation Models and Combined Abnormal Valuation Models

Combined Valuation Models
The empirical results indicate that both earnings and book value are important variables in the
valuation of UK food retailers, since they have significant coefficients for all the accounting years.
This combined valuation model splits equity value MV into two components: current book value (Bt),
an accounting measure of the value of shareholders’ equity investment and earnings (EBITDAt), a
measure of the firm’s ability to earn abnormal profits. The more persistent a firm’s abnormal income,
the higher (lower) the weight that is placed on the EBITDAt (Bt) when determining MV. It can be
noticed that the weighting of earnings increases considerably as we move forward in time (from 1998
to 2001) while the weighting of book value decreases and finally becomes negative. This decline in the
magnitude of the estimated coefficient on book value implies that Bt has shown some tendency to
decrease in value-relevance while the earnings coefficient shows an increase in importance. A possible
explanation for this is an increase in the persistence of abnormal earnings (AE). Following Penman’s
argument, book value can be claimed as relatively less important proxy for future normal earnings so it
receives a lower weight in the last years. Indeed, in the first two years (1998, 1999), the inclusion of
book value in the earnings model results in a dramatic increase in explanatory power (from 0.50 to
0.98 and from 0.61 to 0.86 respectively) while in 2000 and 2001 the addition of Bt increases
explanatory power only marginally from 0.93 to 0.98 and from 0.983 to 0.986 respectively. These
results are consistent with the findings of Rees (1997) that show that UK equity investors place more
emphasis on earnings and less on book value than Canadian investors.
In any case, it can be stated that the combination of current book equity value and earnings
gives a highly satisfactory equity valuation model. Undoubtedly, the inclusion of book value in the
market value-earnings model adds, on average, a great degree of explanatory power, reducing at the
same time the positive bias in the coefficient of earnings in the earnings-based model the first two
years. Particularly, the average value of adjusted R2 equals 0.975, which is higher than that of the
earnings-based model (0.76). Nevertheless, this value is very close to the corresponding value for the
asset model including the separate items of the balance sheet. Generally, the coefficients of both Bt and
EBITDAt are statistically significant and the former is closer to its predicted values of unity.
The model containing the current book value items has an even higher value of R2 (0.991 on
average) which may due to the inclusion of more variables. However, each annual regression has a
different number of significant variables. For instance, in 1999 and 2000 there are only two significant
coefficients while in 1998 and 2001 the number of significant coefficients rises to three. These results
indicate that the potential multicolinearity is not significant, since all the regressions give high value of
R2 along with individually significant coefficients, since serious problems from correlation among the
independent variables arise when R2 is high and at the same time all the coefficients are insignificant.
Principal component analysis gives the same result.
The model that combines earnings with the beginning-of-year book value (Bt-1) gives also a
high value of average adjusted R2 (0.968) which is very close to that of the first combined model. In
this case too, the inclusion even of the previous year’s book value improves the explanatory power of
the earnings model. Both coefficients are statistically significant in all the annual regressions.
However, as in the first combined model, which contains earnings and current book value, the
International Research Journal of Finance and Economics - Issue 7 (2007) 114

magnitude of earnings’ coefficient increases while book value’s weight decreases across time. In fact,
the earnings’ coefficient in 2000 takes the highest value, perhaps reflecting relatively strong growth in
the industry. Analysing the weights of these two variables it can be claimed that during the first two
years, the role of book value as a proxy for expected future normal earnings is important since the
small or even negative earnings observed during this period can not be sustained indefinitely so are not
informative. Thus, unlike book value, current earnings provide a less useful proxy for expected normal
earnings that are mainly reflected in book value. On the other hand, during the last two years earnings
are not as transitory since they indicate a high degree of persistence while book value decreases in
importance. This is also shown by the increase in abnormal earnings. Therefore, in these years current
earnings provide substantial explanatory power beyond book value in equity valuation.
Finally, the joint inclusion of earnings and balance sheet components of t-1 period improves the
earnings model, since the average R2 is 0.992. In particular, in 1998 and 2000 there are three
significant coefficients while in 2001 two. However, in 1999 all the included variables are statistically
significant which implies that this is the most appropriable model for this year. This also proves that
multicolinearity does not affect the results; there are a large number of individually significant
coefficients.
Therefore, the combined valuation model which includes both earnings and book equity value
(current or previous year’s) has the greatest explanatory power and thus is the most applicable model in
equity valuation of the UK food and drug retail sector.

Combined Abnormal Valuation Models

The output of the regression of market value on current book value and abnormal earnings indicates
that, contrary to the findings of Abukari et al. (2000), the value of R2 (0.937) is, on average, lower than
that of the basic combined model which includes earnings instead of abnormal earnings. This means
that the results show that the combined abnormal model has lower explanatory power than the basic
one that simply uses earnings. However, the coefficients of both book value and abnormal earnings are
significant in all years. As for the magnitude of the coefficients, the results are the same as for the
combined models. The weight on abnormal earnings increases while that on book value slightly
decreases over time. In fact, AE coefficient also takes its highest value in 2000. This supports the view
that the persistence of abnormal earnings has increased over the period, a fact which explains the
increase in earnings’ coefficient in the basic combined model along with the decrease in the importance
of book value.
The output of the regression with independent variables beginning-of-year book value and
abnormal income supports the above results. The average adjusted R2 is lower than that of the
corresponding basic combined model while the coefficients remain significant in all the accounting
years. Specifically, since the coefficient on equity book value ranges from 1.4 to 2.8, and we can reject
the null hypothesis that the coefficient on Bt equals one in all but one accounting year. Moreover, the
coefficient on AEt is significantly positive in all the years and ranges from 3.4 to 17.1. In this case, the
weight of abnormal earnings increases while the value-relevance of book value decreases. This is, also,
consistent with the behavior of earnings in the basic combined model.

4.2 Comparison of the Models

As mentioned above, the value of adjusted R2 statistic is used for comparison among econometric
models. Based on this so-called coefficient of determination, one can first notice that the asset-based
models that contain the components of book value, rather than the pure Bt, give higher adjusted R2,
even when the results of the principal component regressions are taken into account. By comparing all
the valuation models we can reach the conclusion that the basic combined model which captures the
spirit of RIM is the most appropriable model for equity valuation. In particular, the models with the
highest average values of R2 (0.99 on average) are the models which combine earnings (EBITDAt) with
balance sheet components, irrespective of whether these items are taken from period t or t-1. Even
when we take the principal component regressions into account, these two models dominate. This
115 International Research Journal of Finance and Economics - Issue 7 (2007)

supports the view of Feltham and Ohslon that the separation of financial from operating activities plays
a significant role in equity valuation.
Furthermore, the Akaike information criterion (AIC) and the Schwarz criterion (SC) are widely
used in model comparison. They are based on the residual sum of squares and penalize extra irrelevant
coefficients included in the models. They penalize for overfitting problems since the redundant
variables cause difficulties in the forecasting process. The model that is chosen, according to these
criteria, is the one with the lowest value of AIC and SC. Although the combined models including the
total book value variable have large explanatory power, the models that give the most robust results are
those that use the separate balance sheet accounting items, supporting again the suggestion of Feltham
and Ohlson. In contrast, the earnings-based model has the biggest values of AIC and SC.
Therefore, the empirical results derived from the financial statements of the UK food retail
industry for the accounting years 1998-2001 support the Feltham and Ohlson model (1995) which
suggests that together the stock and flow components capture to a higher degree, the different aspects
of equity valuation than models strictly based on balance sheet or profit and loss items. In fact, the
separation of the financial from operating assets contributes highly to the precise estimation of equity
values.

5. Conclusions
The empirical tests that are applied to equity valuation for firms in the examined sector are based on
the following models: a) asset-based, b) earnings-based and c) combined valuation model which
captures the spirit of the Feltham and Ohlson (1995) valuation framework. Eleven alternative equity
valuation models are introduced and tested empirically, using the OLS estimation method on a sample
of 10 UK food and drug retailers. These tests include the estimation of linear regressions with the
firms’ equity market values as the dependent variable and various components taken from the financial
statements as independent variables.
Overall, the results of the empirical analysis indicate that the linear accounting-based valuation
model, that incorporates both stock and flow components, provides greater explanatory power and thus
better captures the different aspects of equity values of firms in the UK food retail sector than either
purely asset-based or purely earnings-based models. In particular, the average reported value of
adjusted R2 statistic for the basic combined model is 0.97, compared to 0.86 and 0.75 respectively for
models based only on assets or earnings. Furthermore, the combined model gives the lowest values of
Akaike information criterion and Schwarz criterion. Although one could expect that the combined
model that contains both book value and abnormal earnings would be more informative, the average
value of R2 (0.94) is lower than that of the basic combined models that include earnings as independent
variable.
In fact, the combined models that give the highest explanatory power are those that combine
earnings (EBITDAt) with balance sheet components, irrespective of whether these items are taken from
period t or t-1. The split of book value into separate items intends to capture the spirit of Feltham and
Ohlson model (1995) which suggests that the separation of financial from operating activities plays a
substantial role in equity valuation for these firms.
Thus, the empirical analysis supports the view that the asset-based or the earnings-based model
produces benchmark valuations that can be used as a starting point but cannot capture all the
determinants of equity values. In practice, income before interest, tax, depreciation and amortisation
alone, explains the smallest proportion of cross-sectional variation in equity values. On the other hand,
book value alone gives a satisfactory degree of explanatory power. However, a combination of both
book value and current earnings in a separate valuation model provides a better and more accurate
estimation of equity market price.
In this paper we have assumed a linear relationship in the valuation models and one may
criticize that assumption, as well as the small sample used for empirical testing. However, due to the
specific limitations in time and data, only ten firms in the UK food and drug retail industry and only
International Research Journal of Finance and Economics - Issue 7 (2007) 116

four accounting years were able to be taken into account. Undoubtedly, it would be more accurate to
estimate the models introduced in this paper using larger data series, that is, more firms and more
accounting years.
The paper’s findings are generally consistent with the empirical evidence of prior studies concerning
the Feltham and Ohlson (1995) valuation model suggesting that the combined model is more
informative than models based only on assets or earnings. This accrual accounting valuation model
incorporates the value already recognised in the balance sheet (the book value) and calculates the
difference between balance sheet value and intrinsic value from forecasts of earnings and book value
that are reported in future forecast income statements and balance sheets. These are the two primary
statements in financial accounting which include stock components, that reflect the net ‘stock’ of assets
of a firm at a given point in time, represented by book equity value, and flow components, that denote
the accretion (or reduction) to the net stock of assets during the period, represented by the bottom line
net income. Therefore, with the use of this accrual accounting valuation model, fundamental analysis
can identify mispriced securities and thus yield abnormal returns.

6. Future Research
Moreover, there is scope for further development of this analysis. Rees (1999) found out that the
valuation model is very sensitive to firm characteristics, most notably firm size. Thus, the analysis
could be extended by including an additional variable in the models, which is firm size, which
according to Rees (1997), has a strong impact on the explanatory power and the estimated coefficients,
suggesting that there is a scope for improving the model. Rees finds that firm size is positively related
with value and the results are consistent with either lower cost of capital or higher growth for larger
firms. Barth et al. (1998) state that the inclusion of size is useful since size can be a risk proxy (thus,
mean E/P and B/P ratios for less financially healthy firms would be higher) and a proxy for a variety of
economic phenomena including earnings persistence, accounting practices, political costs and financial
health. Following normal practices, size can be measured as the natural logarithm of the market
capitalisation of equity. In the current study, the sample consists of the ten largest firms of the industry,
fact that mitigates considerably any possible size effect. However, there is some difference in the
relative size of the examined firms since there are six firms that dominate the sector (with turnover
between £21,000 and 3,500 million) while the remaining four firms have turnover between £935 and
380 million. Therefore, including firm size coefficients in the estimated models and thus capturing any
size effect can be expected to reduce the observed temporal instability in the relative strength of the
equity and earnings coefficients.
117 International Research Journal of Finance and Economics - Issue 7 (2007)

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International Research Journal of Finance and Economics - Issue 7 (2007) 118

Appendix
Table 2: Correlation Matrixes among the Independent Variables

PANEL A: 1998

Bt Bt-1 FAt-1 ∆FAt It It-1 NDt NDt-1 NOAt NOAt-1 EBITDAt AEt
Bt 1.00 0.95 0.92 0.61 0.96 0.75 -0.98 -0.94 -0.94 -0.97 0.68 0.68
Bt-1 1.00 0.98 0.58 0.98 0.71 -0.98 -0.92 -0.95 -0.97 0.73 0.69
FAt-1 1.00 0.60 0.96 0.73 -0.99 -0.94 -0.95 -0.98 0.71 0.67
∆FAt 1.00 0.55 0.21 -0.60 -0.44 -0.78 -0.72 0.60 -0.04
It 1.00 0.68 -0.94 -0.87 -0.93 -0.93 0.73 0.75
It-1 1.00 -0.71 -0.89 -0.52 -0.59 0.03 0.75
NDt 1.00 0.94 0.94 0.97 -0.70 -0.60
NDt-1 1.00 0.80 0.86 -0.43 -0.70
NOAt 1.00 0.97 -0.83 -0.47
NOAt-1 1.00 -0.81 -0.52
EBITDAt 1.00 0.27
AEt 1.00

PANEL B: 1999

Bt Bt-1 FAt-1 ∆FAt It It-1 NDt NDt-1 NOAt NOAt-1 EBITDAt AEt
Bt 1.00 0.98 0.94 0.81 0.71 0.96 -0.34 -0.98 -0.97 -0.95 0.67 0.90
Bt-1 1.00 0.97 0.81 0.71 0.96 -0.35 -0.98 -0.97 -0.94 0.66 0.89
FAt-1 1.00 0.84 0.75 0.96 -0.41 -0.99 -0.95 -0.97 0.71 0.88
∆FAt 1.00 0.98 0.87 -0.79 -0.81 -0.65 -0.91 0.94 0.74
It 1.00 0.81 -0.85 -0.72 -0.53 -0.86 0.95 0.66
It-1 1.00 -0.42 -0.94 -0.91 -0.93 0.71 0.91
NDt 1.00 0.41 0.11 0.58 -0.89 -0.21
NDt-1 1.00 0.94 0.94 -0.69 -0.85
NOAt 1.00 0.86 -0.48 -0.89
NOAt-1 1.00 -0.86 -0.85
EBITDAt 1.00 0.61
AEt 1.00

PANEL C: 2000

Bt Bt-1 FAt-1 ∆FAt It It-1 NDt NDt-1 NOAt NOAt-1 EBITDAt AEt
Bt 1.00 0.96 0.98 0.83 0.86 0.74 -0.51 -0.36 -0.98 -0.96 0.97 0.57
Bt-1 1.00 0.95 0.80 0.85 0.71 -0.49 -0.34 -0.98 -0.97 0.95 0.52
FAt-1 1.00 0.82 0.91 0.78 -0.60 -0.46 -0.95 -0.93 0.97 0.56
∆FAt 1.00 0.84 0.86 -0.62 -0.54 -0.80 -0.69 0.91 0.90
It 1.00 0.93 -0.86 -0.77 -0.76 -0.71 0.93 0.66
It-1 1.00 -0.89 -0.85 -0.61 -0.53 0.87 0.81
NDt 1.00 0.98 0.34 0.27 -0.67 -0.57
NDt-1 1.00 0.18 0.11 -0.55 -0.57
NOAt 1.00 0.98 -0.91 -0.51
NOAt-1 1.00 -0.86 -0.38
EBITDAt 1.00 0.72
AEt 1.00
119 International Research Journal of Finance and Economics - Issue 7 (2007)

PANEL D: 2001

Bt Bt-1 FAt-1 ∆FAt It It-1 NDt NDt-1 NOAt NOAt-1 EBITDAt AEt
Bt 1.00 0.97 0.93 0.39 0.94 0.88 -0.36 -0.54 -0.95 -0.97 0.97 0.63
Bt-1 1.00 0.99 0.34 0.92 0.86 -0.32 -0.51 -0.96 -0.98 0.95 0.60
FAt-1 1.00 0.42 0.96 0.92 -0.43 -0.61 -0.92 -0.95 0.98 0.66
∆FAt 1.00 0.57 0.63 -0.89 -0.76 -0.16 -0.21 0.56 0.75
It 1.00 0.98 -0.63 -0.78 -0.80 -0.85 0.97 0.75
It-1 1.00 -0.73 -0.86 -0.71 -0.76 0.94 0.77
NDt 1.00 0.95 0.07 0.15 -0.56 -0.78
NDt-1 1.00 0.26 0.34 -0.70 -0.80
NOAt 1.00 0.97 -0.85 -0.40
NOAt-1 1.00 -0.88 -0.47
EBITDAt 1.00 0.80
AEt 1.00

Table 3: Diagnostic Tests of the Estimated Models (reported values are averages)

JB Test ARCH LM White Het. Test LM Test

Models X2-statistic X2-statistic X2-statistic X2-statistic
(p-value) (p-value) (p-value) (p-value)
Asset-Based Model (Bt) 0.758 7.065 8.596 0.366
(0.692) (0.032) (0.012) (0.711)
Asset-Based Model (components of Bt) 1.528 0.307 0.094 3.834
(0.571) (0.780) (0.910) (0.290)
Asset-Based Model (Bt-1) 0.978 5.404 6.666 0.497
(0.621) (0.181) (0.236) (0.631)
Asset-Based Model (components of Bt-1) 0.759 0.426 7.294 6.358
(0.699) (0.687) (0.395) (0.305)
Earnings-Based Model 6.964 3.935 3.534 1.305
(0.369) (0.374) (0.456) (0.512)
Combined Model (EBITDA-Bt) 3.271 0.222 6.697 1.549
(0.344) (0.825) (0.303) (0.429)
Combined Model (EBITDA-components of Bt) 1.442 0.181 8.024 1.1997
(0.656) (0.835) (0.154) (0.685)
Combined Model (EBITDA-Bt-1) 3.266 0.548 9.367 0.663
(0.317) (0.882) (0.136) (0.445)
Combined Model (EBITDA-components of Bt-1) 1.744 0.355 8.739 0.756
(0.558) (0.742) (0.256) (0.602)
Combined Abnormal Model (AEt - Bt) 1.626 2.447 9.392 2.753
(0.638) 0.378 (0.113) (0.412)
Combined Abnormal Model (AEt - Bt-1) 0.832 3.404 9.124 2.986
(0.513) (0.355) (0.125) (0.437)