Have investors learned from the crisis? An analysis of post-crisis pricing errors and market corrections in US stock markets based on the reverse DCF model

ABSTRACT

The traditional discounted cash flow (DCF) model is generally used to estimate the present value of an enterprise or its equity based on expected future parameters such as cash flows, growth rate and discount rate. In the last decade, the reverse DCF model has gained popularity. With this approach, the valuer uses the current market capitalization as a fixed input and seeks those ‘critical’ values of individual valuation parameters, which – assuming all other parameters remain unchanged – result in a value equal to current market value. This provides a point of comparison for the company’s realized performance and may provide insights regarding over or undervaluation. In this study, we develop a novel DCF model and conduct empirical analysis using data of 1001 US manufacturing, service, retail and financial companies. We examine pricing errors and market corrections in the post-crisis era based on the critical cash flow ratio defined in our reverse model. We find evidence of a general undervaluation in US stock markets with different pricing error patterns across industries. Our results confirm market correction mechanisms have worked properly in the post-crisis era with an average reaction time of 2 years, suggesting investors have learned from the crisis.

KEYWORDS:

• Discounted cash flow
• reverse DCF model
• critical cash flow
• pricing error
• valuation

JEL CLASSIFICATION:

• G12
• G17
• G32

Acknowledgments

The authors express their gratitude to the anonymous reviewers for their constructive comments, and to Professor Gabor Rappai for his help and professional support related to the research.

This research has been conducted as part of the National Excellence in Higher Education Program in Hungary (reference number of the contract: 20765-3/2018/FEKUTSTRAT).

Disclosure statement

No potential conflict of interest was reported by the authors.