A Bayesian approach to equity valuation

Quantitative approaches to equity valuation in common use includemethods based upon the dividend discount model, which equatesthe value of an enterprise to the present value of the dividendsthat it pays to its owners, and methods which begin from therelation between the current share price and the expected earningsfor the next 12 months. A short coming of each of these approachesis that they are forced to take near-term earnings and dividendforecasts as their basic data, when in fact the values theyare trying to estimate are dominated by longer-term considerations.As a result, model estimates are often too sensitive to changesin near-term earnings which have little effect on a company'slong-term prospects. In relatively efficient markets, however, the price of a company'sshares at any time reflects information which is not readilyquantifiable and which may represent a longer-term view. Thatinformation can be used to create a stable quantitative valuationmodel in which the information content of near-term changesis balanced against longer-term considerations via a Bayesianupdating procedure. The structure of the Bayesian valuation model is essentiallythat of a truncated dividend discount model, where the fairvalue today is expressed as the present value of a terminaldividend (i.e. the fair value at a future date, discounted tothe present), plus the present value of the interim dividends.In the Bayesian model, the terminal dividend is a variable whoseprobability distribution depends upon the sequence of earningsbetween the valua tion date and the terminal date.