A study of the reliability of cross-sectional earnings forecasting models for estimating IPO firms’ implied cost of capital

Abstract

Purpose This study aims to evaluate the earnings forecasting models of Hou et al. (J Account Econ, 53:504–526, 2012) and Li and Mohanram (Rev Account Stud, 19:1152–1185, 2014) in terms of bias and accuracy and validity of the implied cost of capital (ICC) estimates for a sample of initial public offerings (IPOs). Design/methodology/approach The authors use a sample of 1,657 NYSE, Amex and Nasdaq IPOs from 1972 to 2013. Findings The models of Hou et al. and Li and Mohanram produce relatively inaccurate and biased earnings forecasts, leading to unreliable ICC estimates, particularly for small and loss-making IPOs that constitute the bulk of new listings. As a remedy, the authors propose a new earnings forecasting model, a combination of Hou et al.’s and Li and Mohanram’s earnings persistence models, and show that it produces more accurate and less biased earnings forecasts and more valid ICC estimates. Originality/value The study contributes novel results to the literature on the validity of cross-sectional earnings models in forecasting IPO firm earnings and estimating the ICC. The findings are directly relevant for practitioners, who can improve their earnings forecasting accuracy for IPO firms and related ICC estimates. The insights can be extended to other settings where investors have limited access to financial information, such as acquisitions of private targets.

IPO performance anomaly: evidence from new aged ventures and loss-making listings in India

“…The dearth of historical data pertaining to stock performance, firm' operations and financials and complex business models enhance the information asymmetry and ambiguity in valuing the firms (Barg et al, 2021;Gerard Sanders and Boivie, 2004;Menon and James, 2022). Studies found the traditional valuation approaches, namely, the comparable firm approach and the discounted cash flow method, inefficacious in capturing the precise estimates of new firms (Berkman et al, 2000;Bilinski and Eames, 2019;Schosser and Str€ obele, 2019;Schreder and Bilinski, 2021). Kim and Ritter (1999) observed the price-earnings, marketto-book and price-to-sales multiples without adjustment to be modestly effective in valuing young ventures (Kim and Ritter, 1999).…”

“…Studies found the traditional valuation approaches, namely, the comparable firm approach and the discounted cash flow method, inefficacious in capturing the precise estimates of new firms (Berkman et al. , 2000; Bilinski and Eames, 2019; Schosser and Ströbele, 2019; Schreder and Bilinski, 2021). Kim and Ritter (1999) observed the price-earnings, market-to-book and price-to-sales multiples without adjustment to be modestly effective in valuing young ventures (Kim and Ritter, 1999).…”