Chapter 8 Valuation of Company Shares: Earnings Based Methods

The objectives of this chapter are to present the earnings based methods of share valuation, to critically appraise the available empirical evidence, and to provide examples of the problems, issues and limitations of share valuation.

Chapter Outline

• Overview of the relationship between earnings and value. • Compounding versus Discounting • Long Event Windows and Discounted/Compounded Earnings. • Earnings Capitalisation and P/E Valuations. • Permanent versus Transitory Earnings and Financial Analysis. • Ohlson’s Theory of Value. • Example of Ohlson Style Valuation.

Why focus on earnings for valuation?

In chapter 7 we argued that cash flow and dividend based valuation models were conceptually and empirically inappropriate. Earnings based valuation methods, in particular Ohlson style valuation models, are shown in this chapter to be conceptually superior to dividend and cash flow valuation approaches. There is growing empirical evidence consistent with our arguments, some of which is reviewed in this chapter. Chapter 9 provides some detailed examples of the Ohlson style earnings valuation methodology and should be studied after digesting the current chapter.
Why focus on earnings? The actions and statements of the professional investment community provide compelling anecdotal evidence that earnings are important in the valuation of company shares. At the aggregate level expected profits and growth in profits impact on market valuation. For example a recent article on the performance of the Dow Jones industrial average commented that the index had stalled just short of a 1000 point gain for 1995 and that “one of the things with which the market is struggling is the course of companies’ profits”(Maggie Urry,