A modified Ohlson (1995) model and its applications

Abstract

In this paper, I explore a modified Ohlson (1995) model, which incorporates future positive net present value (NPV) investments. I first utilize an approach to simultaneously estimate the parameters in the linear information dynamic alongside the cost of equity capital, then evaluate the model’s performance in equity valuation and return prediction. Contrary to the systematic undervaluation of the Ohlson (1995) model reported in prior literature, I find that there is no systematic undervaluation of stock prices by using the modified Ohlson (1995) model. The out-of-sample median valuation bias estimated with this new approach is only 3.3% compared with 34.8% achieved when carrying out the estimation using existing methods. I also find that using the time-varying cost of equity capital reduces valuation bias and improves valuation accuracy. Furthermore, the expected return estimates developed from the model generate a monotonic decile ranking of future realized stock returns.