Ac.F703 Equity Valuation Using Accounting Numbers Summer 2023

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Ac.F703 (Advanced Topics in Accounting)

Equity Valuation Using Accounting Numbers

Summer 2023

MSc in Accounting & Financial Management

MSc in Finance

Outline for Standard Dissertation Topic

A. Overview

This document describes the standard dissertation topic that students are expected to follow on Ac.F703.

Equity valuation is of direct interest to investment professionals such as analysts, portfolio managers, and corporate management. It also represents one of the most important areas in contemporary capital market-based accounting research. The process of accounting-based equity valuation involves modelling and estimating firms’ intrinsic value by analysing and forecasting accounting numbers, translating corporate strategy into expected future returns, and supplementing financial statement data with other (non-financial) drivers of value creation.

Students opting for this topic are required to produce a dissertation consisting of three core components described in more detail below. A dissertation must contain ALL THREE components to qualify for final submission: under no circumstances will students be given the option of replacing a component of the standard dissertation with an extended treatment of one or both of the remaining parts. Therefore, it is strongly suggested that students allocate the appropriate amount of effort and length to each part.

All students are required to address a COMMON research question: whether the reliability of the intrinsic value estimates derived from three flows-based models and a multiples-based model differ. In attempting to shed light on their research question(s), students will be expected to extract and summarise information from the dataset provided (large sample analysis) and to collect and analyse an analyst report(s) of a firm analysed in the large sample analysis (case study). Students are expected to perform statistical analyses on their large sample data.

Students may also select their own research questions. In this case, no individual and additional supports are provided throughout the taught and surgery sessions for their particular research focus. This means that while the selection of alternative research questions provides students with an opportunity to differentiate themselves, their dissertation writing becomes more challenging.

We expect that the overall length of the dissertation to be approximately 8,000 words, and in any case, it must NOT exceed 11,000 words, excluding tables, references, appendices, and footnotes. Please note that this word limit is substantially shorter than the limit of 25,000 words for textual material given in the General Regulations as reproduced in the Courses Handbook.

1. A critical review and synthesis of the valuation and other relevant literature 

This component will account for approximately 25% of the final dissertation mark. Students will be expected to produce a brief summary and critique of the relevant academic literature relating to the use of accounting numbers in business valuation. Some relevant literature will be covered in the Ac.F703 sessions but students will also be expected to identify and discuss other relevant research not directly covered in class. Students must ensure that they address the following areas as part of their review:

· The theoretical links between accounting numbers and firm value, including some consideration of both multiples-based valuation approaches and models using forecasts of accounting flows (e.g., the free cash flow model (DCF), the residual income valuation model (RIVM), and the dividend model (DDM));

· The empirical evidence regarding the application of these valuation models.

Even though a common research question is given, students should develop a testable hypothesis on which valuation model performs better, based on extant theories and empirical evidence.

· One option is to construct your hypothesis based on Francis et al. (2000), i.e., (i) a relatively small proportion of the terminal value of RIVM (ii) less severe distortions in book value of equity and/or the precision and the predictability of residual income. Students may also rely on alternative theories/arguments to construct their own hypothesis. Again, in this case, hypothesis development should be executed independently.

· In doing so, students are expected to briefly discuss the advantages and disadvantages (both theoretical and practical) associated with using different valuation approaches.

2. Large sample statistical analysis

This component will account for approximately 50% of the final dissertation mark. The analysis is intended to compare the performance of valuation models on a large sample of firms, which will be provided to students. The following steps represent core non-negotiable elements that a dissertation must contain to fulfil the requirements of the Ac.F703 dissertation stream. However, students wishing to conduct additional analyses within the context of the structure described below are encouraged to do so (while remaining within the overall word limit for the dissertation). As noted, in this case, no individual and additional supports will be provided for their additional analyses throughout the taught and surgery sessions.

Please note: the following steps provide a structure for your analysis.

Step 1

· Compute value estimates for a large sample of firm-years using three flows-based models (i.e., DDM, DCF, and RIVM);  

· Compute value estimates for a large sample of firm-years using a multiples model.

· You can choose any value driver for your multiples model, e.g., forward earnings measure in Liu et al. (2002).

Required

Draw conclusions about whether the reliability of accounting-based flows models and multiples models differ by comparing their absolute and relative pricing performance.

1. Briefly explain the implementation issues;

· Use 6 per cent of market risk premium, 4 per cent of growth rate and two years of forecast period suggested in Francis et al. (2000).

· Adopt the equity perspective for the DCF forecast.

2. Tabulate descriptive statistics (number of observations, mean, standard deviation, minimum, 1^st quartile, median, 3^rd quartile, maximum of main variables) for each absolute and relative model performance measure;

3. Test the equality of means and medians of valuation errors using the single sample t-test (mean), Wilcoxon signed-rank test (median), and OLS regression. This means that you should use three metrics of bias, accuracy, and explainability;

4. Conduct sensitivity tests by altering market risk premium, growth rate (e.g., 0 per cent or 4 per cent), and forecast period.

Step 2:

· Construct subsamples of High/Low R&D firms using the definition suggested by Francis et al. (2000)

· Ranking your sample firms based on the ratio of Compustat R&D spending to total assets

· Consider the top 25 per cent of firms as the High R&D subsample

· Consider firms with no or immaterial amounts of R&D expenditures as the Low R&D subsample

Required:  

1. Compare the accuracy of value estimates using subsamples of High R&D and Low R&D firms;   

2. Comment on whether the reliability of value estimates is affected by the level of R&D expenses (i.e., potential distortions in the book value of equity).

3. Case study

This component will account for approximately 25% of the final dissertation mark. The analysis is intended to complement and extend insights provided by the large sample analysis by conducting a case study of a firm analysed in Part 2.   

The following steps represent core non-negotiable elements that a dissertation must contain to fulfil the requirements of the Ac.F703 dissertation stream.

Step 3:

· Select A company analysed in Part 2 that you believe to be appropriate to support your conclusion in Part 2, and summarise only briefly the business, industry, and financial status of the company as of the most recent fiscal years (e.g., three to five years; note that there is no pre-determined format for this preliminary analysis).

· You can select any firm from any industry; Francis et al. (2000) argue that industry membership does not affect the performance of valuation models. However, given that value estimates are more likely to be reliable for stable firms, it is suggested to select a firm with sufficient firm years from a stable industry (e.g., manufacturing).

· Relevant data can be acquired from annual reports and/or Thomson EIKON.

Step 4:

· Analyse an analyst report(s) and comment on the valuation models and assumptions employed by analysts.

· Note that your findings in Part 2 address which valuation model analysts seem to use to value equity securities. In this case study, you should investigate whether the practice of analysts is consistent with your findings in Part 2, e.g., whether RIVM (DDM, DCF, multiples) is indeed preferred by analysts in practice and, if not, how analysts mitigate any concerns regarding alternative models (e.g., you may investigate the assumptions adopted by analysts such as growth rate, forecast period, and discount rate). To this end, where appropriate, relate the analyses presented in Part 3 to those in Part 2.

· Note, however, that a case study cannot be generalised; Nonetheless, the goal of this case study is to shed light on the actual valuation process employed by analysts.

· Students can analyse either only one analyst report or multiple reports of different analysts. Selecting only one report will not be penalised.

· Analyst reports can be downloaded from Thomson EIKON.

Required

Support your findings in Part 2 by analysing how analysts value the intrinsic value of firms in terms of the choice of valuation models and assumptions (e.g., growth rate and discount rate). (Note that you are NOT required to conduct any quantitative analysis in this case study).

B. Administration

Students are required to submit the first draft of their dissertation. This draft will be carefully evaluated by the dissertation directors, and detailed feedback will be provided to each student. The aim of this feedback is to give students an indication of how their work is progressing, and what changes and improvements are required to ensure that the dissertation attains the standard required of an MSc student. Please note that we can only provide feedback on the work contained in the first draft. The extent and quality of feedback will therefore be highly correlated with the amount of work submitted. Students who submit a first draft that contains a reasonable attempt at all three dissertation components will receive comprehensive advice and guidance. Students who fail to submit one or more dissertation components at the first draft stage will receive no further help on these parts prior to submission of the final dissertation in September. It should be noted that NO FURTHER HELP OR GUIDANCE OF ANY TYPE WILL BE GIVEN ONCE THE SURGERIES END AND THE FIRST-DRAFT COMMENTS ARE RETURNED.  

Please refer to the ‘Programme Handbook’ for the submission deadline dates.

General Guidance

1. As part of the Ac.F 703 course, students will be required to complete and submit a preliminary piece of empirical analysis relating to accounting-based valuation. Students will work individually. General feedback for students’ submission will be provided. The aim of this preliminary piece of empirical analysis is to ensure that students are completely familiar with the key statistical techniques, computer software, and data that will have to be used to successfully complete the standard dissertation topic. Precise details and the submission deadline of the empirical analysis required will be distributed during the Ac.F703 course.  

2. Your review and synthesis of the relevant literature will be partly based on the material covered in the Ac.F 703 course. However, you should not feel obliged to give detailed coverage of all of the literature covered on the course; some of this literature may cover related areas not central to the topic. Try to ensure that your literature review is focused on the dissertation topic. You will find it necessary to be selective in what you cover.

3. In Parts 2 and 3, you are free to adopt whatever methods you deem to be appropriate. Examples of potential approaches will be reviewed during the Ac.F 703 course.

4. You are strongly advised to start making progress with Part 1 of the dissertation as the AcF 703 course progresses. You should also familiarise yourself with the key data sources and empirical techniques during this period. Failure to keep to this suggested timetable will severely harm your chances of successfully completing the dissertation phase of your degree.

5. You should ensure that Part 1 provides a ‘critical review and synthesis’. A succession of unconnected paraphrases of the abstracts and conclusions of papers will not warrant a good mark. You should also try to ensure that the focus of Part 1 reflects the issues that you will be exploring empirically in Parts 2 and 3.

6. Lack of independence, plagiarism and reliance on unattributed direct quotation from source materials will not be tolerated and will be penalised accordingly.

7. Failure to submit a suitably comprehensive first draft by the stated deadline without preapproval will mean that you will not receive adequate and timely feedback. This in turn will make it difficult for you to produce a final dissertation of adequate quality by the due date for submission of the final dissertation. From the first draft submission date onwards, students will not receive any further supervisory input in the form of surgeries and one-to-one meetings with the dissertation co-ordinators.

8. Failure to submit the final dissertation by the stated deadline without preapproval will be dealt with according to relevant university and departmental policies. Possible consequences range from mark reduction to not graduating in time.