Residual Income Valuation Model Research Articles

ANALYSIS OF THE RESIDUAL INCOME VALUATION AND ABNORMAL EARNINGS GROWTH MODELS: A PRACTICAL APPROACH USING ANALYSTS’ FORECASTS

This paper revisits two valuation models based on accounting figures: the Residual Income Valuation (RIV) and Abnormal Earnings Growth (AEG). Our research design has two approaches: i) we demonstrate theoretical integration of both models; and ii) we show in a practical manner that models converge to the same results based on real data of analysts forecast consensus. We apply statistical tests on empirical data from analyst’s forecasts available on Thomson One Analytics database. We use information of 45 firms listed on the IBovespa segment from BMF&BOVESPA in 2008 with historical data from 2003 to 2007 and analysts’ projections from 2003 to 2010. Our results do not show a significant mean difference of the valuations, but those from the RIV model are more dispersed than those produced by the AEG model. Furthermore, our results are consistent with international evidences and present additional evidences of application of valuation models based on accounting information in Brazil. Our findings support the use of valuation models based on accounting figures by analysts, investors, rating agencies and regulators to provide additional analyses of firm’s future prospects.

Extended Dividend, Cash Flow, and Residual Income Valuation Models: Accounting for Deviations from Ideal Conditions*

AbstractPrevious empirical studies derive the standard equity valuation models (i.e., DDM, RIM, and DCF model) while assuming that ideal conditions, such as infinite payoffs and clean surplus accounting, exist. Because these conditions are rarely met, we extend the standard models by following the fundamental principle of financial statement articulation. We then empirically test the extended models by employing two sets of forecasts: (1) the analyst forecasts provided by Value Line, and (2) the forecasts generated by cross‐sectional regression models. The main result is that our extended models yield considerably smaller valuation errors. Moreover, by constructing these models, we obtain identical value estimates across the extended models. By reestablishing empirical equivalence under nonideal conditions, our approach provides a benchmark that enables us to quantify the errors caused by individual deviations from ideal conditions and thus to analyze the robustness of the standard models. Finally, by providing a level playing field for the different valuation models, our findings have implications for other empirical approaches, for example, estimating the implied cost of capital.

Macroeconomic Factors as Determinants of Company Value in the Context of the Ohlson Residual Income Valuation Model; Greek Findings

Over the past two decades the Ohlson Residual Income Model for equity valuation has drawn much attention concerning its advantages when compared to traditional models (DDM, FCFM). This paper attempts to empirically investigate the validity of the Ohlson Residual Income model using data from the Greek economy over the period 1969-2001. By using multiple regression analysis and by incorporating macroeconomic factors as explanatory variables, we investigate the link of accounting and macroeconomic factors in the market valuation of major Greek companies listed in the Athens Stock exchange. We find that the performance of the Ohlson Residual Income Model is quite satisfactory and the use of factors such as commodity prices, discount rates, and market level in some cases add to the explanatory power of the examined model. Our findings are important for both economists and fund managers, because they show that a relation between accounting and macroeconomic data is valid in the Greek market and economy, alongside more developed markets.

Accounting‐Based Probabilistic Prediction of ROE, the Residual Income Valuation Model and the Assessment of Mispricing in the Swedish Stock Market

Using Swedish stock market data, this study investigates whether an investment strategy based on publicly available accounting information can generate abnormal investment returns. The strategy involves two steps. First, an accounting‐based probabilistic prediction model of changes in the medium‐term book return on owners' equity (ROE) is estimated. Second, market expectations of changes in medium‐term ROE are assessed through observed stock prices and the residual income valuation model. Stock market positions over 36‐month holding periods are taken when the accounting‐based predictions of ROE and the market expectations differ. Over the period 1983–2003, the investment strategy generated values of Jensen's alpha corresponding to an average monthly excess return for a hedge position of up to 0.8% for a sample of manufacturing companies. In the main this hedge return was caused by strong positive returns to the long positions, and additional analyses show that the returns appear to have been affected by a positive market sentiment bias (i.e., positive ROE surprises being associated with stronger price reactions than negative ROE surprises) making out‐of‐sample inferences somewhat dubious. Furthermore, most of the investment returns accrued over holding periods up to around 1995, with no indications of market mispricing over the last third (1995–2003) of the investment period. The empirical results are consistent with market investors having become more sophisticated in their use of publicly available accounting information over time.

Are IPOs Really Underpriced or Overpriced: Evidence from Tehran Stock Exchange

While it is well documented in the literature that IPOs have been consistently underpriced on average of 15% or more over the past three decades all over the world, the recent seminal study by Purnanandam and Swaminathan (2004) report that IPOs are overvalued at the offer price relative to value metrics based on industry peer price multiples. Current study, applying residual income valuation (RIV) model along with comparable firm multiples valuation approach, replicates and expands upon the research by Purnanandam and Swaminathan (2004) by providing evidence from a sample of 162 IPOs floated during 1997-2009 in the Tehran Stock Exchange. The results suggest that: First, Iranian IPOs are underpriced on initial trading window of one month following issue on average of 13.93%. On the long-run performance, the average market-adjusted CARs and BHARs over three years after continuously listing are -6.67 and 0.00 percent, respectively. As a key finding of this study, the valuation results reveals that the sample Iranian IPOs are significantly overvalued compared to peer firms selected on industry and size, and also relative to their intrinsic value derived from the RIV model. This result is inconsistent with the traditional view (mainly asymmetric information based explanations) that IPOs are underpriced at offer price and fairly valued in the aftermarket relative to their matched comparable seasoned firms. However, this finding yields strong support for the investors' sentiment and fads and/or over-optimism argument in the literature.

A Swan Song for the Value Driver Model-Modern Theory and Application of Constant-Growth Equity Valuation Models

In this paper we shed new light on the most widely used terminal valuation tool: the accounting based value driver model (VDM). Based on a purely cash flow-driven approach we identify the requirements necessary for proper application of the VDM under a conservative accounting regime and show that, contrary to pure cash based models, the VDM only works accurately in an aseptic academic environment. A scenario analysis emphasises the noticeable quantitative impact of any violations of these assumptions. Artificially adjusting real world figures to the required aseptic academic environment is principally possible but entails additional workload and bloats the valuation model. We further show that the VDM is not only a fragile valuation tool from a technical/theoretical perspective but also prone to be misused in valuation practice due to its reliance on book rates of return rather than economic rates of return. The paper contributes to the current literature on accounting based equity valuation in various ways, as it shows that the original Gordon/Shapiro (1956)-model is misspecified as long the accounting system exhibits the characteristics of conservativeness, it lends fresh support to the Ritter/Warr (2002) critique of residual income valuation models, it highlights new problems of accounting based valuation models and it introduces new practice-relevant aspects into the discussion about terminal value estimates between Penman/Sougiannis (1998) and Lundholm/O’Keefe (2001 and 2001a). This paper stands for a renunciation of the VDM as well as an embracement of purely cash driven models.

Fundamentals-Based Risk Measurement in Valuation

ABSTRACT: We propose a methodology to incorporate risk measures based on economic fundamentals directly into the valuation model. Fundamentals-based risk adjustment in the residual income valuation model is captured by the covariance of ROE with market-wide factors. We demonstrate a method of estimating covariance risk out of sample based on the accounting beta and betas of size and book-to-market factors in earnings. We show how the covariance risk estimate can be transformed to obtain the fundamentals-based cost of equity. Our empirical analysis shows that value estimates based on fundamental risk adjustment produce significantly smaller deviations from price relative to the CAPM or the Fama-French three-factor model. We further find that our single-factor risk measure, based on the accounting beta alone, captures aspects of risk that are indicated by the book-to-market factor, largely accounting for the “mispricing” of value and growth stocks. Our study highlights the usefulness of accounting numbers in pricing risk beyond their role as trackers of returns-based measures of risk.

Reconciliation of Residual Income and Free Cash-Flow Valuation Models

Ohlson & Juettner-Naworth (2005) show, using a “scheme” developed in Ohlson 1998, 2000, that one can derive the residual income model from the discounted dividend model. However, their method involves the condition that an infinite sum (book value per share) divided by the infinite sum of discount factors will converge towards zero (“mild transversality condition”). Mathematically this needs not be the case as infinity divided by infinity is indeterminate. The following presents two reconciliation methods which are free from the convergence assumption.

The Impact of Expectations Manipulation on the Usefulness of Analyst Forecasts in Firm Valuation*

This paper examines the impact of expectations manipulation on the usefulness of analyst forecasts in the residual income valuation model. Recognizing that firms may guide down analyst forecast to either truthfully communicate information (legitimate guidance) or mislead analysts to produce beatable forecasts (expectations manipulation), this study first develops a measure to isolate expectations manipulation from the overall forecast guidance. It then assesses forecast usefulness by the performance of forecast-based intrinsic value metrics (V) to predict firm value. The results show that V estimated using manipulated forecasts have less ability to explain stock price and predict future returns. These results remain after controlling for firm size, earnings performance, forecast accuracy, etc. Based on these findings, I conclude that expectations manipulation reduces the usefulness of analyst forecasts in firm valuation, as it impairs the performance of forecast-based valuation models to predict firm value.

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.

Comparison of the Residual Income Valuation, Abnormal Earnings Growth and Free Cash Flow Models: An empirical study of the Brazilian capital market

This study compares the explanatory power of the residual income valuation (RIV), abnormal earnings growth (AEG) and free cash flow (FCF) models in the Brazilian capital market, through an empirical test to compare the three models, using data on companies listed on the BOVESPA. Each model was analyzed annually over the period from 1995 to 2002 by multiple linear regression. The results show that from 1995 to 1999 the RIV model had better explanatory power than the other two models, and from 2000 to 2002 the AEG and RIV models were the same, an indicator of the Brazilian market’s development in the more recent years of the study period. The FCF model had the least explanatory power in all the years analyzed. The results were confirmed by panel data analysis.

Análise empírica de modelos de valuation no ambiente brasileiro: fluxo de caixa descontado versus modelo de Ohlson (RIV)

Dentro do contexto controverso de comparações entre modelos de valuation, o presente trabalho investiga, baseado nas projeções dos analistas de mercado de capitais para empresas brasileiras, se existem diferenças entre os valores de uma empresa estimados pelo modelo de fluxo de caixa descontado (DCF) e pelo modelo de Ohlson (modelo de lucros residuais - RIV). Essa abordagem é inovadora à medida que trabalhos já realizados visando à comparação entre esses modelos consideram o valor da empresa calculado com base nas informações publicadas/divulgadas pela empresa e não com base na expectativa dos agentes de mercado (como por exemplo, o analista de mercado de capitais). Entretanto, a correta implementação dos modelos em análise deve ser realizada considerando-se as expectativas dos agentes de mercado. Adicionalmente, são realizadas regressões para verificar qual dos modelos (DCF ou OHLSON) explica melhor a relação preço/valor patrimonial (P/B) de uma empresa em períodos futuros. As conclusões obtidas foram: i) existem diferenças estatisticamente significantes para o valor estimado das empresas pelo fluxo de caixa descontado e pelo modelo de Ohlson (RIV) e ii) os índices P/B, calculados a partir das estimativas dos analistas (que utilizam o DCF), apresentam maior poder explicativo dos índices P/B futuros da empresa do que as estimativas do índice P/B feitas pelo modelo de Ohlson (RIV).

Extended Dividend, Cash Flow and Residual Income Valuation Models - Accounting for Deviations from Ideal Conditions

Standard equity valuation approaches (i.e., DDM, RIM, and DCF model) are derived under the assumption of ideal conditions, such as infinite payoffs and clean surplus accounting. Because these conditions are hardly ever met, we extend the standard approaches, based on the fundamental principle of financial statement articulation. The extended models are then tested empirically by employing two sets of forecasts: (1) analyst forecasts provided by Value Line and (2) forecasts generated by cross-sectional regression models. The main result is that our extended models yield considerably smaller valuation errors. Moreover, by construction, identical value estimates are obtained across the extended models. By reestablishing empirical equivalence under non-ideal conditions, our approach provides a benchmark that enables us to quantify the errors resulting from individual deviations from ideal conditions, and thus, to analyze the robustness of the standard approaches. Finally, by providing a level playing field for the different valuation approaches, our findings have implications for other empirical settings, for example, estimating the implied cost of capital.

Extended Dividend, Cash Flow and Residual Income Valuation Models - Accounting for Deviations from Ideal Conditions

Standard equity valuation approaches (i.e., DDM, RIM, and DCF model) are derived under the assumption of ideal conditions, such as infinite payoffs and clean surplus accounting. Because these conditions are hardly ever met, we extend the standard approaches, based on the fundamental principle of financial statement articulation. The extended models are then tested empirically by employing two sets of forecasts: (1) analyst forecasts provided by Value Line and (2) forecasts generated by cross-sectional regression models. The main result is that our extended models yield considerably smaller valuation errors. Moreover, by construction, identical value estimates are obtained across the extended models. By reestablishing empirical equivalence under non-ideal conditions, our approach provides a benchmark that enables us to quantify the errors resulting from individual deviations from ideal conditions, and thus, to analyze the robustness of the standard approaches. Finally, by providing a level playing field for the different valuation approaches, our findings have implications for other empirical settings, for example, estimating the implied cost of capital.

Accounting Valuation Models: A Short Primer

This note discusses basic issues related to residual income valuation (RIV) and abnormal earnings growth (AEG) models but has only scratched the surface of a complex subject. What clearly emerges from this ‘primer’ is the conclusion that AEG is a more complex valuation model than RIV. This complexity concerns both the mechanics and interpretation of AEG compared to RIV. Furthermore, a study by Penman (2005) raises a question about the usefulness of AEG compared to RIV. His comparisons between RIV and AEG are rather remarkable and suggest that RIV gives estimates of value which are more accurate and less variable than estimates based on AEG. Clearly, these results need further study.

Australian Evidence Regarding the Value-Relevance of Technical Information

This paper employs an unconstrained version of Ohlson's (1995) residual income valuation model to evaluate the value-relevance of technical information in Australia. Specifically, we employ the methodology of Bettman, Sault and Welch (2006) to investigate whether models that incorporate both fundamental and technical measures are superior to models that consider either fundamental or technical information in isolation. Preliminary testing confirms the positive dependence of contemporaneous price with the fundamental factors commonly employed in modelling, namely book value per share, earnings per share and consensus earnings forecasts. Supplementation of fundamental models with three technical variables sees all technical factors being significant in explaining contemporaneous share prices, consistent with US evidence provided by Bettman, Sault and Welch (2006). Overall, our results provide further evidence that augmenting fundamental valuation models with technical information yields models with greater explanatory power than those that only consider fundamental or technical information in isolation.

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.

Unrecorded Intangible Assets: Abnormal Earnings and Valuation

We use the unique banking industry setting to demonstrate the impact of unrecorded intangible assets on abnormal earnings and equity valuation in the context of the residual income valuation model. We show that the persistence of bank abnormal earnings and, consequently, the pricing multiples on bank abnormal earnings, vary with the level of unrecorded intangible assets. Our evidence suggests that unrecorded intangible assets are important in understanding the persistence and valuation of abnormal earnings in the banking industry. The analysis framework introduced in this paper could also be used to examine the valuation impacts of intangible assets in other industries.

Fundamentals-Based Risk Measurement in Valuation

We propose a methodology to incorporate risk measures based on economic fundamentals directly in the valuation model. Fundamentals-based risk adjustment in the residual income valuation model is captured by the covariance of excess ROE with market-wide factors. We simplify the covariance risk adjustment such that it can be easily implemented in a practical valuation setting. We demonstrate a method of estimating covariance risk out of sample based on the accounting beta and betas of size and book-to-market factors in earnings. Our empirical analysis shows that value estimates based on fundamental risk adjustment produce significantly smaller deviations from price compared to value estimates based on standard risk adjustment procedures using the CAPM or the Fama-French three-factor model. Further, we find that our single-factor risk measure, based on the accounting beta alone, captures aspects of risk that are indicated by the book-to-market factor and largely explains the mispricing of value and growth stocks. The paper highlights the usefulness of accounting numbers in pricing risk beyond their role as trackers of returns-based measures of risk. Accounting risk measures are based on firm fundamentals that indicate the source of risk and hence the use of these measures directly in valuation is appealing.

Value Relevance of Book Value, Retained Earnings and Dividends: Premium vs. Discount Firms

This paper argues that from the perspective of both the residual income and option-style valuation models, the relative valuation roles of earnings, book value and dividends should differ fundamentally between firms that trade at a premium vis-a-vis discount to book value. We hypothesise and find that earnings (book value) have a more important role in equity valuation when firms trade at a premium (discount) to book value. We also find that if one controls for the premium/discount condition of the firm, other known influential conditions, such as the sign of earnings (Collins et al. 1999) and relative levels of earnings and book value (Burgstahler and Dichev 1997), become inconsequential. The discovered relationships between the discount/premium characteristic of the firm and the relative valuation roles of book value, earnings and dividends are robust to the effect of time, informational environment and the industry of the firm.