2020/15 | LEM Working Paper Series | |
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Uncertainty in Firm Valuation and a Cross-Sectional Misvaluation Measure |
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Giulio Bottazzi, Francesco Cordoni, Giulia Livieri and Stefano Marmi |
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Keywords | ||
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Stochastic Discounted Cash Flow; Valuation Uncertainty; Valuation Factor; Kalman Filter.
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JEL Classifications | ||
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G11, G17, G32
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Abstract | ||
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In all investment decisions it is important to determine the degree of uncertainty associated
with the valuation of a company. We propose an original and robust methodology to company
valuation which replaces the traditional point estimate of the conventional Discounted Cash
Flow (DCF) with a probability distribution of fair values. It hinges on two main ingredients: an
econometric model for the company revenues and a set of firm-specific balance sheet relations
that are estimated using historical data. The effectiveness and scope of our methodology are
explored through a series of statistical exercises on publicly traded U.S. companies. We show
that an uncertainty-adjusted indicator of mispricing, derived from the fair value distribution, is
capable of predicting future abnormal returns. Then, we construct a new long-short valuation
factor and we test that it is not redundant for describing average returns when used to augment
traditional market factor models.
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