Ratio models for the valuation of equity sequrities

Abstract

It has been suggested that the objective of the accounting measurement process should be to produce an earnings number that could be used as a measure of a firm's value and indeed financial analysts use accounting data to get an estimate of a company's price. This paper is a cross sectional study on British company data over a 17 years period which examines the performance of alternative valuation ratios (price earnings ratio, market to book value ratio, price dividends ratio) as predictive rules of the market capitalization of a corporation. We use the results of Ballas (1991) about the correct mathematical specification of ratios that involve market data as the numerator and accounting data as the denominator to test for the best definition of earnings and book value of assets which minimizes the dispersion around the mean of the ratio. Subsequently, the performance of the best price earnings ratio is compared to that of the market to book value ratio and the price dividends ratio as well as that of a combined forecast methodology. Finally, tests for industry effects were carried out which indicate that industry effects are of small economic sig¬nificance.