Income growth, forecasting and stock valuation

Abstract

We show that using forecasts of a firm's income growth in the context of stock valuation can lead to overpricing of the firm's stock, which is consistent with 'optimism bias' reported among financial analysts. Firms with volatile earnings, high income growth and low systematic risk are prone to larger valuation errors. To address this issue, we develop a new estimator of the firm value that corrects for the bias from forecasting income growth. The new estimator is significantly superior to the traditional value estimator under various performance measures. To support managerial decision-making, we construct closed-form confidence intervals for the firm value and the implied cost of capital that account for uncertainty in income growth.