The Value Relevance of Earnings and Book Value Using an Option-Style Equity Valuation Model: Evidence from Korea

Abstract

The purpose of this paper is to investigate the value relevance of earnings and book value in security prices from 1982 to 2001 in Korean stock market. The study examines whether the accounting earnings and book value have a nonlinear relationship to equity value by using an option-style model of equity. The study uses an option-style model of equity value to test the hypothesis that earnings and book value have a nonlinear relationship to equity value by examining firms listed in the Korean stock market (7,928 firm-year observations). To this end, the paper performs analyses for all samples and across subsamples divided into loss firms and profit firms, and observes changes in relationships over the past twenty years. This paper reports three sets of findings. First, the value-relevance of accounting earnings differs between loss firms and profit firms. Second, Korean firms differently acknowledge accounting earnings and book value for equity valuation. Third, an option-style valuation model can explain the nonlinear relationship between equity value and accounting earnings/book value. The important contribution of the study is to show the nonlinear relationship between equity value and book value in the Korean stock market. And the empirical results of the paper reinforces the adoption of a new equity valuation model that explicitly recognized the option that firms have to adapt their resources to the alternative uses available to them.