CHAPTER 7

A Fair Representation? Broad Sample Testing over a 10-Year Market Cycle

As Chapters 5 and 6 indicate, our basic valuation approach appears to produce sensible empirical results. The next logical step would be to expand the sample size dramatically and attempt to validate the model at key points in recent market history.

Our goal is to estimate reasonable and consistent values for the expected risk premium over inflation for the unleveraged firm:

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We do this by observing market values of each firm’s equity and debt values, VL and D, at selected points in time, namely calendar year-end 1995, 2000, and 2005. These dates cover a sufficiently long and normal economic cycle to level out anomalies across our entire sample. In addition, the period in question covers the most extreme market value conditions in recent years, the market bubble of the late 1990s and 2000. High observed values of this risk premium, or inflation-adjusted discount rate, indicate that an equity is cheap by historical standards. Low values indicate the opposite.1

In order to carry out the analysis, we need to have obtained reasonable values for both the franchise value reinvestment fraction, f, and the real unleveraged, perpetual, after-tax, inflation-adjusted return on equity (ROE), z. We can utilize historical financial statement results to estimate f. For the profitability variable z, we utilize ...

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