Can a Hybrid Method Improve Equity Valuation? An Empirical Evaluation of the Ohlson and Johannesson (2016) Model

Abstract

This paper investigates the validity and usefulness of “hybrid” valuation models. We recast the model in Ohlson and Johannesson (2016) as a hybrid of the Dividend Discount Model and an earnings-based price multiple model, and develop a new hybrid model that generalizes the Residual Income Valuation Model. After validating the theoretical properties of these models' unique parameters, we assess the usefulness of the hybrid models in two applications. In application one, we find that intrinsic values from the hybrid models are more accurate than those from common discounted models or price multiple models. These improvements are attributable to the hybrid models' ability to incorporate stock price and more realistic assumptions about growth. In application two, we find that the implied cost of equity from the hybrid models better captures systematic risks and key idiosyncratic risks, and captures expected returns. These results demonstrate the validity and usefulness of hybrid valuation models. JEL Classifications: G12; G14; G17; G31; M41. Data Availability: The data used are publicly available from the sources cited in the text.

Value investing via Bayesian inference

“…While they are assumed to not be the sole proxy for conservatism- Khan and Watts (2009) also employ Size and Leverage-they represent the difference in earnings recognized in the accounting and future earnings implied by market expectations. That is one reason why the hybrid RIM derived by Gao et al (2019) reduces the negative valuation bias in RIM-based approaches, as it incorporates the contemporaneous "normal" P/B (ϕ b ), leading to our fourth modeling variant of intrinsic value: Circularity problems concerning market (in)efficiency aside, reducing valuation bias is one of the advantages of multiple-based valuation-it captures market-wide developments in the time series and considers that firms and peers are often priced in similar ways. In turn, we use the hybrid model as the fourth proxy for cheapness.…”

“…These results apply to portfolios sorted on cheapness alone and conditional sorts combined with quality. For monthly returns, portfolios sorted on B/P and the Gao et al (2019) hybrid model yield comparable Sharpe ratios and shares of positive returns. It, therefore, seems that accounting for uncertainty mainly pays off for longer holding periods.…”

Optimal equity valuation using multiples: The number of comparable firms

“…They find that the estimation of fair market values in this way leads to trading strategies that can earn abnormal profits. Gao et al (2019) develop a hybrid valuation model by combining the advantage principles of multiples-valuation approach and standard discount models. They show that their hybrid model outperforms the price-to-earnings multiple which Liu et al (2002) find performs remarkably well.…”

Alternative costs of equity of coal mining companies taking into account a context of the Russian Invasion into Ukraine

“…The causal effect of arbitrage limits on asset pricing anomalies using SHO regulation program is weakened for portfolios created using pilot stocks (Chu et al, 2020). Gao et al (2019) examine the validity and utility of hybrid valuation models that generalize residual income valuation model. The authors state that the internal value of hybrid models are more precise and the implied costs of equity better capture the systematic risks and expected returns.…”