David J. Ashton

Residual Income Valuation Models and Inflation

Existing empirical evidence suggests that residual income valuation models based on historical cost accounting considerably underestimate equity values. One possible explanation is the use of historical cost accounting under inflationary conditions. In this paper, we use a residual income framework to explore theoretically how historical cost accounting numbers need to be adjusted for inflation in forecasting and valuation. We demonstrate that even in a simple setting where inflation is running at a relatively low level, residual income models are likely to produce severe under-valuations if inflation is not properly taken into account. We use simulated data to reinforce our theoretical findings and to illustrate the difficulties that empirical investigators face working within the confines imposed by real data.

Linear information dynamics, aggregation, dividends and ‘dirty surplus’ accounting

Abstract We generalise the Ashton et al. (2003) Aggregation Theorem by demonstrating how the market value of equity disaggregates into its recursion and real (adaptation) components when the linear information dynamics incorporate a dirty surplus adjustment and also, when dividends are paid. Our analysis shows that ignoring the dirty surplus adjustment will, in general, induce biases into the functional expressions for the recursion and real (adaptation) values of equity. Furthermore, we show that whilst the recursion value of equity is independent of dividend policy, the real (adaptation) value of equity is affected by the dividend policy invoked by the firm. Tabulated results show that the difference in equity value between a dividend and a non-dividend paying firm is most pronounced at low levels of the recursion value.

Textbook Formulae and UK Taxation: Modigliani and Miller Revisited

Abstract One of the less satisfactory features in the education of UK students of corporate finance is the presentation of formulae developed within the context of the US system of taxation. In this paper, the standard formulae of corporate finance are reworked with the context of the UK system of corporate and personal taxes.

The Cost of Equity Capital and a Generalisation of the Dividend Growth Model

Abstract In this paper a generalisation of the dividend growth model is developed. This model relates the growth in dividends to a companys earnings and asset base. The resulting model involves the solution of an eigenvalue system of equations. It is shown how a closed form approximation to this system exists. The econometric procedures that might be used to parameterise the model are considered, and the methodology is illustrated using five UK Companies.

Tax, corporate behaviour and the foreign income dividend scheme

A model is derived which considers the interactions of corporation tax, advance corporation tax (ACT) and capital gains tax and their impact on UK corporate behaviour. It is shown that the recent changes to the ACT system, in the form of the Foreign Income Dividend (FID) scheme, will increase the gearing ratios of those firms affected by the changes. Debt will become more attractive, since it no longer increases irrecoverable ACT by reducing taxable profits. Furthermore, retention rates will fall, since retentions no longer serve as an ACT shield. Copyright Blackwell Publishers Ltd 1997.

Conservatism in residual income models: : theory and supporting evidence

In this paper, we develop a framework for evaluating the impact of conservative accounting on the structure of residual income models of equity valuation. We explore specific examples of both unconditional and conditional conservatism and observe a common mathematical structure. We proceed to generalise our model and identify the joint dependency of conservatism and the persistence of abnormal earnings on the weights attached to book values, earnings and dividends. We are able to show theoretically the likely numerical impact of conservatism on price-earnings ratios and under-valuations produced by residual income models. We investigate empirically the interaction between conservatism and persistence and find they accord well with the theory developed. We briefly discuss the implications of testing the effect of conservatism on valuation and linear information dynamics.

Evaluating the Information Content of Earnings Forecasts

This study develops a framework to compare the ability of alternative earnings forecast approaches to capture the market expectation of future earnings. Given prior evidence of analysts’ systematic optimistic bias, we decompose earnings surprises into analysts’ earnings surprises and adjustments based on alternative forecasting models. An equal market response to these two components indicates that the associated earnings forecast is a sufficient estimate of the market expectation of future earnings. To apply our framework, we examine four recent regression-based earnings forecasting models, alongside a simple earnings-based random walk model and analysts’ forecasts. Using the earnings forecasts of the model that satisfies our sufficiency condition, we identify a set of stocks for which the market is unduly pessimistic about future earnings. The investment strategy of buying and holding these stocks generates statistically significant abnormal returns. We offer an explanation as to why this and similar strategies might be successful.

Analysts’ Optimism in Earnings Forecasts and Biases in Estimates of Implied Cost of Equity Capital and Long-Run Growth Rate

Using a value-weighted rather than an equally weighted regression, Easton and Sommers (2007) show that the upward bias in the risk premium implied by analysts’ earnings forecasts falls to 1.6%, but remains statistically and economically significant. In this paper, we argue that any estimation of a forward risk premium implies a joint test of analysts’ optimism and the implied cost of capital model applied. Employing the recent model developed by Ashton and Wang (2010), we first find that the impact of any bias attributable to analysts’ forecasts can be reduced to a statistically insignificant 0.4%. Second, we show that our estimates of the implied equity risk premium after removing the effect of this bias are between 3.57% and 3.62%. Third, we show that the real estimates of earnings growth from their model seem more plausible.