The dynamics of firms' abnormal earnings and the growth differential between market and book value of equity

Aiming at finding out the interaction effects between corporate governance, accounting measures (BVE and NI) and market value, we suggest three pathways of market value transmission pathway: performance pathway, direct pathway and capital maintenance pathway, with Partial Least Square (PLS) regression model we analyze the relationship between corporate governance mechanisms, Book Value of Equity (BVE), Net Income (NI) and Market Value of Equity (MVE) basing on a sample of manufacture companies in China A share market from 2007 to 2011. Result shows that most corporate mechanisms which have significant relationships with BVE and NI are significantly related with MVE simultaneously, validating the transmission pathway hypothesis. As for the corporate mechanisms whose significance directions are different among NI, BVE and MVE, we explain them from the perspective of basic features of the variances themselves, the efficiency of transmission pathway and influence direction.

Value-relevance research is an important domain of modern capital market research. Accounting researchers have used the value-relevance research framework in many ways with the aim of measuring whether accounting information has a predicted association with equity market values. One of the most widely used models in value-relevance research is a modification of the Ohlson (1995) market valuation model in which the market value of a firm's equity is presumed to be a function of its book value of equity and abnormal earnings. Furthermore, using the Ohlson (1995) model, accounting researchers have documented the value relevance of different types of financial and non-financial information. Drawing on a selected number of recently published studies that have documented the value relevance of different types of financial and non-financial information, this chapter reviews and integrates recent findings, highlighting challenges and providing future directions for further research in this area.

This Research discusses the concept of valuation and its different roles and corporate valuation and its different techniques, also this research discusses two techniques of equity valuation which are book value of equity and market value of equity. To measure created value for shareholder has been the issue of study all over the world. It became a crucial issue since the firms were increasingly committed to create shareholder value. In this research, we will present a definition and analysis for shareholder value creation as compared to equity valuation methods such as book value of equity and market value of equity. In order to understand this concept well, we will apply the “Created Shareholder Value” model proposed by Pablo Fernandez on the telecommunications sector in the Egyptian market through a case study of listed companies, Orascom Telecom Holding (OTH) and Telecom Egypt (TE) from 2008 to 2012. To measure the value created for shareholders, we have to define the “increase of equity market value”, “the shareholder value added”, “the shareholder return” and “the equity required return”. It is important not to mix up the created shareholder value with any of the other concepts mentioned before. All of those concepts will be discussed and analyzed in this paper. When the shareholder return exceeds the required return to equity, a firm creates value for its shareholders. This study also showed that although, in certain years, the companies under study have high values of equity book value and equity market value, they didn’t create value for their shareholders since the shareholder return was less than the equity required return in those years.

We examine foreclosures on FHA single family mortgages insured during 1975-87. The importance of the market value of borrower equity, and of the dispersion of national house prices support much earlier work emphasizing the key role of negative equity in triggering default. The lower the mean market value of equity is, and the greater dispersion is, the more borrowers will be likely to have negative equity. The unemployment rate and the book value of borrower equity also are significant determinants of default. Unemployment is one event that can force borrowers to move. The decision to move increases the likelihood of default, because moving costs no longer deter default, and the costs of selling the house reduce the effective equity in the house. The book value of equity also is relevant to this decision, because it is what sellers will receive if they move without defaulting. Both of these variables are significant determinants of default, but the employment impact rises as book equity declines (with large book equity, unemployment should not matter, because selling the house is preferred to default).

I examine the relative valuation importance of book value of equity and net income of financially distressed firms that subsequently resolve their problem of financial difficulties through a merger or entering bankruptcy. Recent studies examine the complimentary roles of book value of equity and earnings in valuing equity. Book value of equity is more value-relevant for financially distressed (bankrupt) firms and earnings are more value-relevant for healthy (non-bankrupt) firms. However, these findings are consistent with two competing theories. I distinguish between these two theories and show that only book value of equity is significantly associated with market value for distressed firms that are bankruptcy candidates. For distressed firms that are merger candidates, I show that both book value of equity and net income are significantly associated with market value. The empirical evidence also provides a direct link between the alternative valuation roles of book value of equity and market value of equity. The results are robust after controlling for non-recurring items, industry, firm size and agency conflicts.

Decomposing value: Changes in size or changes in book-to-market?

We apply the methodology of Knez and Ready (KR) (1997) to data from the Japanese stock market and reexamine the robustness of the risk premium for the market value of equity (MVE). In particular, we compare two alternative explanations for the relation between stock returns and MVE: the one pointed out by Fama and French (FF) (1992) and the other proposed by Berk (1995). Consistent with results for the U.S. market, when we check FF's explanation for MVE, we find that the risk premium for MVE is not robust against extreme observations. Besides the evidence supporting KR's findings, we study the role of MVE proposed by Berk (1995), who points out that under controlled expected cash flows, MVE will be negatively correlated with expected returns. After showing that MVE negatively correlates with risk in the presence of expected cash flows, we test the robustness of the relation between returns and MVE. We find that the estimated risk premium for MVE is robust when realized cash flows (earnings plus depreciation) or book value of equity (BE) is used as a proxy for expected cash flows.

Comment

We examine foreclosures on FHA single‐family mortgages insured during the 1975–87 period. The importance of the market value of borrower equity and national house price dispersion support much earlier work emphasizing the key role of negative equity in triggering default. The lower is “mean” market‐value equity, and the greater is dispersion, the greater is the fraction of borrowers likely to have negative equity. The unemployment rate and the book value of borrower equity are also shown to be significant determinants of default. Unemployment is one of those events that can force borrowers to move. The moving decision increases the likelihood of default because moving costs no longer deter default, and the costs of selling the house reduce the effective equity in the house. The book value of equity is relevant to this decision because it is what the sellers receive if they move without defaulting. Not only are both of these variables significant determinants of default, but the smaller is book equity, the greater is employment impact (with large book equity, unemployment should not matter because selling the house is preferred to default).

We find, as predicted, that the differential ability of accrual and cash flow components of earnings to help forecast future abnormal earnings and the persistence of the components results in the components having different valuation implications. We base our tests on Ohlson (1999) applied to fourteen industries. We find: (1) Accruals and cash flows aid in forecasting future abnormal earnings incremental to abnormal earnings and equity book value. (2) Accruals and cash flows provide explanatory power for equity market value incremental to equity book value and abnormal earnings. (3) There is evidence that accruals and cash flows valuation coefficients are consistent with the Ohlson model.

PurposeThis paper aims to analyze the association between goodwill defined as difference between market and book value of equity and reports of nonrecurring items, namely, special items, discontinued operations and extraordinary items to suggest information related to restructuring activities measured by these items can link the valuation and incentive roles of accounting. Economic intuition suggests that successful managerial efforts should increase firm value. Yet, the link between the valuation and stewardship roles of earnings has been difficult to verify.Design/methodology/approachThe author first estimates whether nonrecurring items have an incremental ability to explain goodwill, measured as the difference between market and book value of equity, at the industry level and then estimates whether firm-specific accounting bias is associated with the industry-level signals sent by nonrecurring items. The author then analyzes whether these items are associated with the use of chief executive officer (CEO) market-based compensation.FindingsThe author’ results show that information contained in special items increases firm-specific goodwill, indicating that it sends signals to investors about future growth opportunities, while that of discontinued operations reduces goodwill, suggesting that it provides signals about the adjustments of book value. She does not find any significant informational role for extraordinary items. She also finds that the signals sent by special items are negatively associated with the use of CEO market-based compensation, while those relayed by discontinued operations are positively associated with the use of market-based pay.Research limitations/implicationsContrary to prior studies, the results show special items and discontinued operations are both value and incentive relevant. There are two caveats to this analysis. First, owing to the frequent changes in the definition of discontinued operations, the analysis is conducted using data between 1992 and 2003. Second, some might argue that industry-level incremental R2 might not be appropriate for a compensation analysis. However, entities often use industry norms as a benchmark to set CEO compensation. Thus, it is reasonable to think that industry-level signals matter for executive pay.Originality/valueThe author’s findings suggest that compensation committees in firms across industries consider the information contained in special items and discontinued operations, and selectively alter the level of incentives to encourage managerial efforts.

This article explores whether the correlation between risk and the market value of equity can explain the premium obtained by investment strategies based on the ratio of book value to market value of equity (BV/MV). Using data from the Japanese stock market, I show that the relationship between BV/MV and risk is weak. I find that two factors contribute to this result. First, market value correlates not only with risk but also with variables measuring liquidity and past performance. Second, book value of equity has a strong correlation with financial risk. Overall evidence suggests that the high correlation between book value and risk reduces the role of market value as a risk proxy and makes other information contained in market value appear to be the main source of the BV/MV premium.

Purpose – This study aims to investigate the persistence ability of accounting variables, namely, abnormal earnings, book value, accruals and cash flows over a period of time and their valuation relevance in Indian scenario. Design/methodology/approach – The study utilizes the generalized version of the Ohlson model which links market prices with abnormal earnings, book value and earning components (accruals and cash flows). Fixed-effect panel data regression is used to analyze six years of data on the sample units to determine the persistence and valuation relevance. Findings – The findings provide evidence on the construct of persistence and value relevance of earnings and book value of equity in the Indian context. The findings further confirm that investors in India are fixated on earnings and fail to attend separately to the cash flow and accrual components of earnings while undertaking their investment decisions. Practical implications – The empirical findings of the study will enable the analysts and investors to understand the relevance and persistence of accounting variables in case of an emerging market like India. Originality/value – The study extends the extant literature on value relevance studies in developed markets to an emerging market like India and enriches it in several ways.

This paper investigates the economic determinants of the R&D economic asset of the firm estimated from past information of R&D expenditures. The study applies the cost basis framework, earlier used for instance by Chan et al. (2001) and Chambers et al. (2001) to estimate the proportion of R&D costs of the firm that represents the investments in R&D capital. The study investigates how different firm-specific characteristics like R&D intensity, profitability, sales growth, size and risk are associated with the ratio of the economic R&D asset to the difference between the market and book value of equity, i.e. the R&D capital ratio. This study extends the current literature by investigating the proportion of R&D costs that represents investment in R&D capital in different countries and industries. The results give evidence that the estimated proportion of the R&D expenses that represents investments in R&D capital is large in all countries and industries. The results also indicate that the ratio of the economic R&D asset to the difference between the market and book value of equity can be explained by different firm-specific characteristics, especially profitability and growth. This study gives international and industry-specific evidence that the R&D capital ratio makes economic sense and thus contributes to the literature that investigates the economic relevance of the R&D capital, especially Ballester et al. (2002).

Equity book values should not exceed equity market values if a firm’s return on equity exceeds its cost of capital or it employs conservative accounting. Yet, equity book-to-market ratios greater than one (BTM > 1) are pervasive and persistent. We address whether BTM > 1 reflects low market values or high book values and, if so, why. We find BTM > 1 reflects low equity market values associated with macroeconomic risk, and thus generates higher hedge returns than equity book-to market ratios less than one (BTM 1 also reflects potentially overstated equity book values. BTM 1 identifies risk and accounting characteristics different from those of other BTM levels and call into question using a single BTM-based factor to predict returns for BTM >1, BTM as a generic indicator of conservative accounting, and BTM > 1 as the key indicator of overstated asset book values.