Uncertainty in Firm Valuation and a Cross-Sectional Misvaluation Measure

Abstract

We are indebted to Giacomo Toscano and Iacopo Raffaelli for helpful comments and fruitful discussion. We are grateful to participants at the Quantitative Finance Workshop Qfw2020 (Napoli, January 28-30, 2020). We also thank David Hirshleifer and Danling Jiang for providing us the UMO factor data.

Stock Recommendations from Stochastic Discounted Cash Flows

“…We propose two recommendation systems based on the comparison of observed market prices with the fair value distributions obtained through the SDCF method introduced in Bottazzi et al (2020). The Single-Stock Quantile system derives recommendations for each company by computing the probability of the observed market price given the fair value distribution of the company.…”

“…We provide a short review of the procedure below. For more details the reader is referred to Bottazzi et al (2020). Given the difficulty in estimating the debt cash-flow with the available data, we adopt an Unlevered Free Cash Flow (UFCF) approach and derive the present value of equity V 0 from the present value of the firm V 0 subtracting the current value of "debt"…”

“…The models are calibrated at the level of the single firm. For each firm we select the best performing model and we use it in a Monte Carlo exercise to generate future revenues realizations which, substituted in (3), produce a distribution of V 0 values (see Bottazzi et al (2020) for further details on model selection). The distribution of firm present values is adjusted using (1) and divided by the number of company's outstanding shares to obtain the fair value distribution.…”

“…In this work we investigate whether investors can profit from two stocks recommendations systems constructed by using the information provided by the Stochastic Discounted Cash Flow (SDCF, henceforth) analysis, a new approach for the estimation of the shareholder value proposed by the authors of the present work in Bottazzi et al (2020). The SDCF is a fairly general and theoretically grounded econometric methodology which allows to replace the pointwise estimate of the conventional discounted cash flow method with a random variable whose empirical distribution, the fair value distribution, can be used to obtain both an estimate of the expected fair value of the company and of its degree of uncertainty.…”