Pengguo Wang

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.

Towards an understanding of profitability analysis within the residual income valuation framework

Abstract This paper argues that there is a mis-match between formal theoretical accounting valuation models, and practical approaches to profitability analysis and valuation. In particular, none of the linear information models published to date exhibit an obvious role for profitability analysis. For example, in the standard Ohlson model, earnings and book value apparently summarise all the value relevant information available from the firms financial statements and there is no apparent need for any further investigation of the accounting numbers beyond these specific line items. The purpose of this paper is to attempt to investigate potential analytical links between formal valuation models and practical profitability analysis. Specifically, we attempt to show how key features of practical profitability analysis might be incorporated into formal valuation models. In this respect there are two particular aspects of valuation practice to which the formal models published to date have paid no attention. First, in practice we often see explicit reference made to the demand side (sales), and supply side (costs) of the business. Second, we often see attempts to benchmark the financial ratios of one firm against the corresponding ratios of firms in the same industry. The purpose of this paper is to attempt to explain why such practices make sense in the context of an attempt to model the principal determinants of firm value within a residual income valuation framework.

The role of disaggregation of earnings in stock valuation and earnings forecasting

This paper compares and contrasts two accounting information systems, the aggregate earnings system and the disaggregated cash flow/accrual system, examining their relative performance in stock valuation and in forecasting of earnings. It finds, in general, that the forecasts of earnings and predicted market values from the cash flow and accrual system have smaller forecasting errors than those from the aggregate earnings system. The adjusted R-squareds from the disaggregated system are in the main higher than those from the aggregated system when considering the explanatory power of the model-predicted values. The results also show that the cash flow and accrual system forecasts dominate the aggregate earnings system forecasts in a large majority of industries.

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.

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.