Implementing Residual Income Valuation With Linear Information Dynamics

Abstract

Residual income (RI) valuation is a method of estimating firm value based on expected future accounting numbers. This study documents the necessity of using linear information models (LIMs) of the time series of accounting numbers in valuation. I find that recent studies that make ad hoc modifications to the LIMs contain internal inconsistencies and violate the no arbitrage assumption. I outline a method for modifying the LIMs while preserving internal consistency. I also find that when estimated as a time series, the LIMs of Ohlson (1995), and Feltham and Ohlson (1995) provide value estimates no better than book value alone. By comparing the implied price coefficients to coefficients from a price level regression, I find that the models imply inefficient weightings on the accounting numbers. Furthermore, the median conservatism parameter of Feltham and Ohlson (1995) is significantly negative, contrary to the model's prediction, for even the most conservative firms. To explain these failures, I estimate a LIM from a more carefully modeled accounting system that provides two parameters of conservatism (the income parameter and the book value parameter). However, this model also fails to capture the true stochastic relationship among accounting variables. More complex models tend to provide noisier estimates of firm value than more parsimonious models.

Relationship between abnormal earnings persistence, industry structure, and market share in Brazilian public firms

“…CAPM), it is assumed that the risk premium predicted by CAPM will be reflected by either abnormal earnings, in the case of an anticipation of future losses, or other information, in the case of not being registered by accounting. It is also worth mentioning previous empirical studies that have applied CAPM as the cost of capital in order to estimate abnormal earnings (Myers, 1999) and have been not successful in delivering significantly different results from those obtained when the a risk-free interest rate is applied (T-Bill Yield) (Cheng, 2005).…”

“…For instance, Myers (1999) uses CAPM as the cost of capital instead of the risk-free interest rate. However, considering the accounting conservatism that does not allow the recognition of the risk-premium associated to an investment, the effect of the cost of capital will be reflected by other information.…”

“…48-67, Jan./Mar. 2011 www.anpad.org.br/bar information models enable the development of valuation models based on empirically testable accounting data and suggest a link between contemporary accounting figures and future abnormal earnings (Myers, 1999).…”

The Impact of Voluntary Corporate Disclosures on the Ex ante Cost of Capital for Swiss Firms

“…A second concern relates to the linear information dynamics in either Ohlson ( 1995) or Feltham and Ohlson ( 1995) that deals with the time-series behavior of abnormal earnings. No such restriction on the relation between current information and future residual income is considered (see Myers, 1999).…”

Value-Growth Investment Strategy: Evidence Based on the Residual Income Valuation Model

“…Overall, this paper shows and concludes that the "rational school" proposed to explain the value effect is not satisfactory empirically. Myers (1999) argues that accounting conservatism may influence the long-run residual income series. Thus, this specification includes a conservatism parameter which is captured by 12  , the book value effect of residual income.…”