Linear Information Dynamics Research Articles

Do sustainability disclosure mechanisms reduce market myopia? Evidence from European sustainability companies

Market myopia is a behavioural bias that causes investors to overvalue short-term earnings and undervalue long-term profits. This anomaly should not be compatible with sustainability disclosure mechanisms, the set of tools which firms use for reporting on their sustainable practices, and which contribute towards long-term performance improvements. Our aim is to study whether market myopia, as a symptom of market inefficiency, decreases with the implementation of sustainability disclosure mechanisms. We test for the presence of market myopia in a sample of firms listed on the S&P Europe 350 Index. For this purpose, we propose to use an adaptation of the valuation model for residual income under linear information dynamics developed by Felthan and Ohlson. Using the rating provided by RobecoSAM Sustainability Yearbook, we find market myopia to be less prevalent in companies classified as high sustainability reporters. An association is also found between persistent enforcement of sustainability disclosure mechanisms and a reduction of the market myopia effect.

A Conceptual Framework for A Corporate Finance Valuation Method

The Ohlson Model and its variants have been widely studied by researchers for value relevance of accounting information. It has been used to predict share prices and to assess the fundamental value of a firm. The original Ohlson Model does not clearly define the non-accounting information variables as the linear information dynamics variables. In relation to that, we propose a conceptual framework that includes the Piotroski F-Score, trading liquidity and systematic risk as the linear information dynamics variables in the Ohlson Model to improve prediction of share prices and forecasting capacity of the Ohlson Model or to better evaluate the fundamental value of the firm. Literature pertaining to Ohlson Model, Piotroski F-Score, trading liquidity and systematic risk are analysed, compared and synthesized to fulfil the research objective. It is expected that this paper will motivate future researchers to conduct more research in this field.

Valuation Role of Accounting Information in Profit and Loss Firms

Purpose of the research: This study identifiesthe most important value-relevant factor across profit and loss companies listed on the Korean Securities Exchange over the period 2000 to 2015.Weaim to improve understanding of the role of accounting information provided by financial statements in firm value across companies. Materials and methods: We use the residual income valuation model of Ohlson (1995). Results: The impact of accounting information on enterprise value is significantly different across profit and loss companies. We believe that this phenomenon occurs because of the assumption of linear information dynamics in theresidual income model. These findings show that accounting information of profitable companies is likely to reflect on the future firm value; however, accounting information of loss companies tends to provide no such information to financial markets.

Diagnostics to Evaluate Cost of Capital Measures. Discussion of Christodoulou et al.

Christodoulou et al. () develop measures of the cost of equity capital that require only accounting inputs, using as an identification strategy the linear information dynamics of Feltham and Ohlson (). I propose to test these measures by evaluating the predictability of innovations to abnormal earnings using various predetermined variables. The over‐identifying restrictions of this model require these innovations not to be predictable. Using a generalized model, I observe that the estimated measures are probably too low. I conjecture that this anomaly, which occurs jointly with a positive drift in abnormal earnings, is caused by the omission of economic assets such as intangibles.

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.

Abnormal Earnings Persistence in the Jordanian Context

This paper tested the abnormal earnings persistence in the Jordanian context through Ohlson’s (1995) first Linear Information Dynamics (LID) Model using an unbalanced panel regression analysis for a sample of (840) public firms listed in the Amman Security Exchange during the period 2007 to 2011. The results showed a highly value relevance for the industrial, financial and services sectors indicated by the coefficient of the abnormal earnings persistence. The services sector had the highest value relevance. However, the industrial and the financial sectors were closed. Finally, the results for the detailed industry analysis of the sub-sectors had shown different values for the coefficient of the abnormal earnings persistence, and bank firms, printing & packaging firms, and the utilities & communication firms had the highest values for the coefficient of the abnormal earnings persistence.

The Effect Of Other Information On Equity Valuation: Kuwait Evidence

Previous studies on the value relevance of accounting information adopt Ohlsons linear information dynamics which, if other information is ignored, leads to a theoretical valuation model solely involving earnings, book value, and net shareholder cash flows or (net dividends). The lack of analysis of other value-relevant data may defeat the effectiveness of the Ohlsons model since the current accounting data cannot fully account for future earnings. The potential implication of ignoring other information is that it could introduce bias into estimated coefficients (e.g. Ohlson, 1995; Hand and Landsman, 2005). This study examines the effect of introducing other information proxied by lagged valuation error on equity valuation, utilizing a sample of non-financial companies listed at the Kuwait Stock Exchange (KSE) over the period 2003 to 2009. Empirical results of this study reveal that our proxy for other information appears to capture valuation implications of information other than current variables in the linear information dynamic setting. Results also reveal that adding other information to the valuation model clearly reduces the coefficients on earnings and dividends, and increases the coefficient of book value; however, book value and earnings remain significantly associated with stock prices. As a consequence, current accounting variables appear to be capturing some, but not all, of other information when this variable is omitted. We conclude that other information is an important factor in determining the market value of firms and hence should not be omitted in studies examining the value relevance of accounting information.

Conservatism and the Ohlson Model

In this paper, we develop a framework for evaluating the impact of conservative accounting on the structure of residual income models of equity valuation. This affords a theoretical model of the signs and sizes of the valuation weights attached to book values, earnings and dividends as a function of conservatism. We proceed to generalize our model of conservatism and are able to show theoretically the likely numerical impact of conservatism on book values, price-earnings ratios and under valuations produced by residual income models. We investigate empirically the dependency of these valuation weights on conservatism using US data over the period 1963-2006 and find that they accord well with the theory developed. Finally, we explore the associated linear information dynamics and find strong evidence that the time-series properties of abnormal earnings are consistent with our model of accounting conservatism.

The Role of Non-Accounting Information in Understanding Stock Return Volatility

Uncertainty about firms' future payoffs is the dominant factor in explaining stock return volatility at the firm level. However, summary financial statement numbers such as earnings only provide a limited measure of expected payoffs, as they do not reflect firms' fundamentals on a timely basis. We demonstrate theoretically and empirically that information about firms' fundamentals contained in analysts' forecasts (which we label as information) is expected to influence future stock return volatility. When combined with Ohlson's (1995) linear information dynamics, the accounting version of the Campbell-Shiller model (Campbell and Shiller 1988a, 1988b; Vuolteenaho 2002) implies that if current non-accounting information is more uncertain, then future stock returns are expected to be more volatile. Our empirical evidence supports the theoretical predictions, and the results are valid for measures of both systematic and idiosyncratic volatility. Additional analysis yields some evidence that both favourable and unfavourable news from non-accounting information increases future stock return volatility. Overall, our results highlight the relevance of information in analysts' forecasts beyond what is contained in the current financial statements.

The value relevance of R&D across profit and loss firms

We examine whether the valuation relevance of R&D documented for loss firms extends to profit firms. We use the residual-income valuation model and show that the valuation multiplier on R&D expenditures is likely to be negative (positive) for profit (loss) firms. This occurs because the linear information dynamics assumption of the residual-income model is more appropriate for profit firms than loss firms. Earnings of profit firms are likely to contain information on the future benefits of R&D activity, however, earnings of loss firms do not contain such information. The empirical evidence confirms our predictions for profit and loss firms. An important implication of our findings is that understanding the role of the R&D expense line item in valuation across firms and within firms, across time depends on whether the linear information dynamics assumption of the residual-income model is applicable for the sample of firms under investigation.

Valuation Weights and Accounting Conservatism

In this paper we develop a general framework for evaluating the impact of conservative accounting on the structure of residual income models of equity valuation. This affords a theoretical understanding of the signs and sizes of the valuation weights observed in regression studies of the relationship between prices, book values, earnings and dividends. We proceed to generalize our model of conservatism and are able to show theoretically the likely numerical impact of conservatism on book values, price-earnings ratios and under valuations produced by residual income models. The analysis also affords an understanding of the limitations of empirical investigations of conservatism using linear information dynamics and hence to explain the failure of many such studies to detect conservatism.

The Influence of Forecast Dispersion on the Incremental Explanatory Power of Earnings, Book Value, and Analyst Forecasts on Market Prices

This study investigates the influence of analyst forecast dispersion on Ohlson's (2001) proposed linear information dynamics where consensus analyst forecasts are suggested as a proxy for other information. Our results indicate that Ohlson's proposed valuation model is most descriptive of market pricing when forecast dispersion, and hence information asymmetry, is high. Our results also suggest that when analysts are confronted with high information asymmetry, they tend to focus less on accounting fundamentals and rely more on other nonaccounting information, thus decreasing the correlation between the explanatory power of analyst forecasts and that of earnings and book value.

The Uncertainty of Non-Accounting Information in Analysts' Forecasts and Stock Return Volatility

This study proposes and validates “other information” in analysts’ forecasts as a legitimate proxy for future cash flows, and examines its incremental role in explaining stock return volatility. We suggest that “other information” contains information about fundamentals beyond that reflected in current financial statements, and reflects firms’ fundamentals on a more timely basis than dividends or earnings. The link between “other information” and volatility can be derived from a combination of the accounting version of the Campbell-Shiller model (Campbell and Shiller 1988a, 1988b; Vuolteenaho 2002) and Ohlson’s (1995) linear information dynamics. Using standardized regressions we find volatility increases when current “other information” is more uncertain, and increases more in response to unfavorable news compared to favorable news. Variance decomposition analysis shows that the variance contribution of “other information” dominates that of expected-return news. The incremental role of “other information” is at least half of the effect of earnings in explaining future volatility. The results are valid for measures of both systematic and idiosyncratic volatility, and are more pronounced for firms with poor information environments. Overall, our results highlight the importance of including “other information” as an additional cash-flow proxy in future studies of stock prices and volatility.

Binomial basis for linear information dynamics: real options, dividends and the valuation of equity

AbstractAnalytical research has confirmed that real options give rise to the kind of nonlinearities observed in practice between equity prices and the figures appearing on corporate financial statements. We develop these real option values in terms of a quasi ‘supply‐side’ model of linear information dynamics based on simple discrete time binomial filtration processes. Our analysis shows that the linear models that pervade the empirical (and analytical) work of the area, will almost certainly suffer from an omitted variables problem. Parameter estimation will then be inconsistent and inefficient.

Is the Relationship Between Equity Value and Accounting Information Non-Linear? Empirical Evidence from Japan

ABSTRACT Accounting information is vital for equity valuation. An issue that intrigues academic researchers, as well as investors and policy makers, is how equity value is related to accounting data. Ohlson (1995) developed a formal model that integrates earnings, equity book values and “other information component” via residual income valuation (RIM) and linear information dynamics (LIM) for valuing equity. Ohlson assumed the model to be linear and additive. However, in an important refinement of Ohlson's valuation model, Burgstahler and Dichev (1997) hypothesize and empirically provide evidence that the relationship between equity value and earnings and book value is non-linear based on the idea that firms have the option to discontinue unprofitable operations and adapt resources to alternative business uses. Burgstahler and Dichev find that the extent of association of equity value with earnings and book value is dependent on the level of the success of the firm. When the firm is “successful,” earnings is the more important determinant of equity value and when the firm is unsuccessful, book value is the more important determinant of equity value. Their empirical result was consistent with this proposition. The present study employs their methodology to evaluate whether the relationship between equity market value and accounting information departs from the linearity assumption in Japan. Using a large sample over a longer period of time, this study finds evidence that Burgstahler and Dichev's proposition also holds in Japan, although the result is weaker compared to U.S. result.

What do Analysts' Forecasts Reveal about Analysts' Private Information?*

Analysts often provide forecasts of one-year ahead earnings, earnings two years ahead, as well as long-term earnings growth rates. In this paper, we assume that analysts make earnings forecasts consistent with abnormal earnings exhibiting linear information dynamics (LID) in Ohlson (1995). Under this assumption, each analysts' consensus earnings forecast is determined by three components: analysts' private/other information about future abnormal earnings (not in current abnormal earnings), the persistence in this private/other information, and the persistence in abnormal earnings. For firms with three contemporaneous multi-period earnings forecasts available, we develop a procedure to infer these three implied components from analysts' forecast for each individual firm year. We begin by examining whether analysts' earnings forecasts exhibit LID. We find that LID is not an appropriate description of analysts' information processing for 22% of our firm-year observations. For the remaining 78%, the two symmetrical combinations of the (median) persistence in other information and abnormal earnings are (0.79, 0.36) and (0.36, 0.79). Demonstrating that the two symmetrical combinations of the persistence parameters lead to the same price estimate, we then calculate the predicted firm value (incorporating analysts' private information). Our results show that the predicted firm value is statistically associated with the observed market value. In addition, when abnormal earnings are expressed as an ARMA (2,1) process, the median persistence in current abnormal earnings into forecasted future abnormal earnings is 0.94 and the median persistence in lagged abnormal earnings into forecasted future abnormal earnings is 0.15. Lastly, we show that the association between return and the innovations in other information is statistically significant.

Differences in the valuation of earnings and book value: Regulation effects or industry effects?

This paper uses a valuation framework on a sample of firms from four European countries (France, Germany, Netherlands, and United Kingdom) to examine how income, accruals, and book value of equity are perceived by the respective capital markets. Our model includes adjustments for industry effects and taking into account the linear information dynamics of the accounting variables posited in the Ohlson model. Consistent with previous researchers, we find that both earnings and book value of equity have valuation implications and that there is significant dispersion in the country-specific and industry-specific valuation multiples. However, when using accounting variables to forecast market values we find that industry-specific valuation multiples reduce forecasting error more than country-specific ones.

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

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.

Ohlson Model Testability: Empirical Tests Findings

This paper analyses the empirical testability of Ohlson Model (OM). The methodology used comprises: (i) exploratory research with regards to the study objective; (ii) bibliography research with regards to the applicable procedures; and (iii) qualitative research with regards to problem approach. Literature research has comprised both origin (dividend discount, assessment of residual income etc) and the model subjacent theory. The linear information dynamics (LID) and the assessment formulae were discussed concerning the model internal consistency, as well as the establishment of the required inputs (parameters and variables). Empirical studies have been analyzed both in terms of their structuring and their achieved results. The study has concluded that: (1) no consensus has yet been achieved over the appropriate way to measure the parameters of persistency; (2) doubts as to the appropriate way of capturing the parameters and , and the variable prevents verification of the effective explanatory capabilities of the Ohlson Model; (3) empirical testability is limited to absences of consistent proxies that may capture persistency and previsibility of the institution’s future income.

European Differences in the Valuation of Earnings and Book Value: Regulation Effects or Industry Effects?

This paper uses a valuation framework for a sample of firms from four European countries (France, Germany, Netherlands, and United Kingdom) to examine how are their accounting income and book value of equity perceived by the respective capital markets after taking into account industry effects. The empirical model, based on Ohlson (1995), posits relationship between income, and book value of equity and market prices. In our tests we take into account the time series properties (linear information dynamics) of the accounting variables posited in the Ohlson model and, in a separate model, we test for the accrual adjustments in earnings. Consistently with previous researchers we find that both earnings and book value of equity have valuation implications, that there are significant country specific differences in the valuation multiples but the differences are substantially reduced when we take into account industry effects.