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


  • Accepted by Jeffrey Callen. The authors are grateful to Jeff Abarbanell, Lucie Courteau, Günter Franke, Joachim Gassen, Wayne Landsman, Christian Leuz, and Peter Pope for their valuable comments. This paper has also benefited from the comments of participants in the 2007 GOR Conference, the 2008 WHU Campus for Finance Research Conference, the 2008 Midwest Finance Association Meeting, the 2008 Eastern Finance Association Meeting, the VI Workshop on Empirical Research in Financial Accounting, the 2008 European Accounting Association Doctoral Colloquium, the 2008 European Accounting Association Conference, the 2008 German Academic Association for Business Research Meeting, the 2008 German Finance Association Annual Meeting, the 2008 Symposium on Finance, Banking, and Insurance, and the research seminar at the University of Bozen and the University of Cologne. We also owe thanks to two anonymous referees of this journal and Jeffrey L. Callen (associate editor).


Previous empirical studies derive the standard equity valuation models (i.e., DDM, RIM, and DCF model) while assuming that ideal conditions, such as infinite payoffs and clean surplus accounting, exist. Because these conditions are rarely met, we extend the standard models by following the fundamental principle of financial statement articulation. We then empirically test the extended models by employing two sets of forecasts: (1) the analyst forecasts provided by Value Line, and (2) the forecasts generated by cross-sectional regression models. The main result is that our extended models yield considerably smaller valuation errors. Moreover, by constructing these models, we obtain identical value estimates across the extended models. By reestablishing empirical equivalence under nonideal conditions, our approach provides a benchmark that enables us to quantify the errors caused by individual deviations from ideal conditions and thus to analyze the robustness of the standard models. Finally, by providing a level playing field for the different valuation models, our findings have implications for other empirical approaches, for example, estimating the implied cost of capital.