Université Paris IX Dauphine Revisiting Ohlson's Equity Valuation Model

The Ohlson model (OM) builds on the accounting-based residual income valuation (RIV) model for equity valuation then specifies a linear information model (LIM) for the time-series behavior of residual income. As a result, stock price is related through a simple linear formula to current book value, current profitability and future profitability. Despites its common theoretical ground with the widely used discounted cash flow (DCF) method, there was a perception among empiricists that OM performed better than DCF when implemented over a finite horizon. In this work, we show that this claim is unfounded and that both OM and RIV yield similar results to DCF when implemented correctly. Specifically we first review three common mistakes made in empirical studies supporting the claim, which led to model the steady-state continuation period in a non-consistent fashion across valuation methods. Second, we describe how the Gordon-Shapiro formula can be rewritten as a linear information model. Still we believe in the superiority of OM which consists in the formalization of LIM. It provides a framework to better capture the value drivers which should eventually yield better results in derivative OM models. The research should now focus on its main challenges of determining the value drivers and forecasting earnings