Does sophisticated DCF outperform heuristics driven PE? Evidence from India

Purpose PE and DCF are two popular valuation methodologies used by analysts to derive target price forecasts while performing equity research. Recent studies in developed markets show that analysts using sophisticated models like DCF produce more accurate target price forecasts as compared to heuristics driven models like PE. This study investigates if analysts using DCF outperform analysts using PE in an emerging market institutional set up. Design/methodology/approach An in-depth analysis of 392 equity research reports is conducted to understand the dominant valuation model used by analysts to derive target price forecasts. Research reports with clear mention of valuation methodology (PE or DCF) to derive target price forecast are used for the purpose of performing this analysis. Multivariate OLS and logit regression analysis has been conducted to investigate if analysts using DCF outperform analysts using PE to derive target price forecasts. Findings The study finds that analysts using PE produce significantly better short-term results than analysts using DCF i.e. when target price accuracy is measured anytime during forecast horizon of 12 months. However, there is no significant difference in target price performance or target price forecast error of PE and DCF model when analyst performance is measured at the end of the forecast horizon. Practical implications In contrast to results from developed markets, this study does not find evidence of superior target price performance of DCF. On the contrary, results suggest that PE outperforms DCF on the short-term measure of target price accuracy. This study shows that PE model which captures market moods and sentiments effectively is more suitable in dynamic, emerging markets like India. Originality/value Past studies have explored the performance of PE and DCF in developed markets and this study provides fresh empirical evidence on target price accuracy of valuation model from an emerging market like India. The superior short-term target price performance of PE as compared to DCF may be relevant exclusively in emerging markets like India.