Investment Performance of Residual Income Valuation Models on the German Stock Market

Abstract

This paper analyses value-investing strategies based on the residual income valuation approach which has become popular due to the work of Ohlson (1995) and Feltham and Ohlson (1995) for the German stock market. Plenty of empirical evidence shows that it is possible to earn positive abnormal returns by investing in on the basis of simple fundamental ratios such as PE ratio, PB ratio, or dividend yield undervalued stocks. A price-value (PV) ratio calculated with the residual income approach is theoretically better founded than the simple ratios mentioned above as it captures all value-generating aspects. Four model specifications are developed and their performance when using them for value-investing strategies is compared to the performance of the simple ratios for German companies over a period of 1990 - 2002. It turns out that fundamentally undervalued companies indeed earn higher returns but the results are statistically weak and the theoretically superior models do not perform significantly better than the simple ratios.