A UK Test of an Inflation‐Adjusted Ohlson Model

Abstract

This paper conducts a UK test of a version of the Ohlson (1995) model. We should only expect abnormal earnings to revert to zero if the book value of assets is economically meaningful. In this paper we make use of the property revaluations common in UK accounts, but estimate other asset values and earnings in inflation-adjusted terms. This, we argue, gives rise to estimates of abnormal earnings that can reasonably be expected to revert to zero. We then test this modified model on UK data using the Dechow, Hutton and Sloan (1999) method. In line with the predictions of the Ohlson model, we find that these modified abnormal earnings appear to mean revert, and that a first order autoregressive process is sufficient to capture the persistence of UK real abnormal earnings. The modified abnormal earnings model in general predicts one year ahead earnings more successfully than an unmodified model. Furthermore, for much of the sample period, one year ahead predictions of abnormal earnings are better for the real model during periods of higher inflation. The undervaluation problem found in prior studies appears to be replaced with an overvaluation problem in the real model which is more acute during periods of high inflation. Last, we show that an estimate of the model based upon an industry level specification appears to perform no better than a market-wide specification of the model. Copyright Blackwell Publishers Ltd, 2005.

Explaining the Cross-Sectional Patterns of UK Expected Stock Returns: The Effect of Intangibles

“…The analysis presented has investigated whether intangibles accrue to a value investment strategy based upon the inflation-adjusted Ohlson model of Gregory, Saleh and Tucker (2005). In so doing, the paper also explores whether .…”

“…In particular, the paper aims to build on the modified version of the Ohlson model proposed by Gregory, Saleh and Tucker (2005), hereafter referred to as GST (2005). Thus, this paper will provide additional evidence regarding whether the abnormal returns found from "value" versus "glamour" investing strategies are largely associated with a naive over-extrapolation of past earnings alone or whether they also account for the intangible effects.…”

Fundamental valuation of extra-financial information

“…20 Since we estimate the RI regression cross-sectionally, the deflation is especially important in our study. Dechow et al (1999), McCrae and Nilsson (2001), and Gregory et al (2005) all show that a first order autoregressive process is generally sufficient to capture the persistence of RI for their data samples of US, Swedish and UK firms. Due to data restrictions, we cannot test whether a one year time lag is sufficient for EFI to be reflected in RI.…”

“…Brown et al (1999) allude to this as well. 19 For this reason, we additionally deflate all variables by the market value of equity per share as, for example, in Dechow et al (1999), Gregory et al (2005), and Pfeil (2003), in order to mitigate problems related to the scale effect. 20 Since we estimate the RI regression cross-sectionally, the deflation is especially important in our study.…”

A Literature Review on Ohlson (1995)

“…This innovation is actually worthyfor theanalytic purpose, but it raises a general question of why abnormal earnings and other information variables are expected to mean-revert to zero (Gregory et al, 2005).…”