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This study investigates the explanatory power of the clean surplus versus prospect theory valuation models. Literature argues the approaches are consistent from a theoretical perspective (Levy, De Giorgi and Hens 2012). To the authors' knowledge, this the first empirical study to compare comprehensively these approaches, in particular, before and after the 2008 financial crisis. The clean surplus model appears to be a better predictor of firm value than prospect theory. The study is comprehensive with base case analyses, and model performance in regards to growth options, size/risk factors, and the pre/post 2008 crash periods.
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INTRODUCTION
Theoretical literature (Levy, De Giorgi and Hens 2012) claims prospect theory and traditional linear risk/retum capital market theory (as may be evidenced by the clean-surplus approach) are consistent. Prospect theory (as is discussed in detail later in this paper) takes a behavioral approach to investment decision-making where the value of gains (e.g., earnings) diminishes as one makes more money above a reference point (e.g., book value). On the other hand, the clean-surplus model presumes a "rational" expectation of a positive linear relation of earnings and firm investment value. Ultimately, investors and researchers should be interested in the characteristics of theoretical drivers of firm value in the stock market so as to facilitate the best allocation of resources in the context of firm valuation. Therefore, we have a motivation for this study's major purpose which is to empirically compare whether the clean surplus model (Ohlson, 1995) or the prospect theory model (Kahneman and Tversky,1979) better explains firm value in a variety of circumstances.
Richardson, et al. (2010) cite the clean surplus model as the best place to begin fundamental analyses of firm value. However, past literature has raised concerns about the clean surplus theory. For example, Lyle et al. (2013) question the clean surplus theory in terms of risk and return. And so, the aforementioned work helps motivate the current work's empirical research focus.
The current study empirically tests the rigor of the Ohlson model against the alternative behavioral economics proposition based on Kahneman and Tversky's prospect theory. This study's methodology will cover the following conditions: 1) pre/post 2008 crash subsamples 2), model formulations without and with growth options, 3) high/low risk subsamples and 4)...