Abstract
This article distinguishes earnings risk from prospective earnings variability, and identifies accounting systems in which earnings volatility is a reasonable proxy for risk. Then, it investigates the impact of earnings risk on reservation values within a Jorgensonian setting. Solving the optimal purchase and divestiture problems reveals that the buyer's and seller's respective reservation values (both generically denoted V) take the form V = B(s) b + X(s) x Here b is book value, x earnings, s parametrizes risk, and B and X are respectively the book value and earnings valuation multiples. In a world with bigger risk s, purchasers demand greater B and accept smaller X while, in contrast, divestors demand greater X and accept smaller B. This suggests that transactors with longer term stakes (buyers) emphasize book value while those with more immediate time horizons (sellers) fixate on earnings. The riskier the prospective earnings stream, the truer this thumb rule.
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