Residual Income Valuation Research Articles

Resolving the Reliance on Fixed Estimation Dates in the Implied Cost of Equity Capital Approach

Abstract Our study’s objective is to develop and analyze a dynamic approach for estimating firms’ expected cost of equity capital. We contribute to the literature by enabling the usage of any required estimation date, resolving the major shortcoming of the existing models—their reliance on one fixed estimation date. This paper presents our model and discusses it from the perspective of the extant body of literature. We show that the current state of the art approach in dynamic estimation does not satisfy theoretical and practical demands, and offers scope for significant improvements. We conduct our analysis by specially considering capital market efficiency, the consistent appreciation of cash flows with respect to timing, and straightforward practical implementation for researchers and practitioners. Building on semi-strong capital market efficiency, the analysis reveals further insights into residual income valuation as we demonstrate that any realization of residual income in the course of the year is irrelevant to valuation in the absence of dividend realization. Consequently, assumptions regarding the shape of earnings in the course of the year are also irrelevant to valuation. Additionally, our theoretically founded model conveniently facilitates the undistorted incorporation of different fiscal year-ends in large samples and avoids stale measures of expected cost of equity capital.

The Cross-Section of Expected Stock Returns: New Evidence from an Emerging Market

ABSTRACTOver 300 factors have been found to explain the cross-section of expected stock returns. Empirical studies also show that findings from multifactor asset-pricing models have not been consistent in an emerging market. Using DuPont analysis and a residual income valuation model for 284 nonfinancial companies on Ho Chi Minh Stock Exchange during the period 2008–2014, findings suggest that the return on equity and its change are informative for stock returns in Vietnam. In addition, the level of capital turnover, financial cost ratio (FCR), and changes in capital and in the FCR contain incremental explanatory power for stock returns.

Value-relevance of disclosure: risk factors and risk management in Brazilian firms

ABSTRACT This study investigated whether the disclosure in accounting reports of information on risk and its management affects, at the margin, firm valuations in the Brazilian capital market. It questioned the existence of value relevance in the disclosure of information related to risk factors and risk management structures. The importance of the topic arises from the documentation that disclosure on risk factors plays a statistically significant role in valuing firms in a context marked by economic and political uncertainty, as is the case of the Brazilian market. The findings confirmed that information about risk shows informational relevance for firm valuations. Information on risk management in a firm, in turn, was not shown to be significant in terms of affecting company share valuations. The investigation of detailed reports with different risk factors indicated that individualized information shows different degrees of relevance for company valuations. It is inferred that the disclosure of risk factors affects the perception of investors, who also base their estimates of return on the availability and detail of such information. It is also observed that information on risk management structure was not shown to be value relevant; moreover, few firms published information on the establishment of this type of entity in their management structures. The residual income valuation (RIV) model (Ohlson, 1995) was applied using regressions with panel data estimation related to the three years covering 2012 to 2014. The sample, which was randomly delimited, was formed of 100 companies. The data on disclosure of risk and disclosure of risk management were collected from the companies’ Reference Forms, available from the website of the São Paulo Stock, Commodities, and Futures Exchange (BM&FBOVESPA). As an impact on the area of knowledge, broader discussions are expected regarding the utility of disclosure on the topic related to risk factors and the existence of a specific body responsible for risk management in firms, according to investors’ perceptions. It also contributes by providing evidence about the quality of disclosure related to risk (factors and management) and the perception of the capital market regarding the informativeness and relevance of such elements.

Secondary Equity Offerings Long Run Underperformance: Puzzle or Mistake

This study examines whether misvaluation which causes long run underperformance is present when firms issue additional equity and if firms time the additional equity issue when market as a whole overvalues the firms, in order to capitalise on the value appreciation. The overvaluation is measured as the difference between the market value of the issuing firm 30 days prior to the equity issue date and the fundamental value of the firm 1 year prior to the day of equity issue. The fundamental value is quantified using the residual income valuation method. The results are partially consistent with the existing empirical literature, as misvaluation is present when firms issue additional equity. However, firms do not specifically time the issuance of equity with overall market overvaluation as based on the results collected, more additional equity were issued when misvaluation levels were lower.

Impact of Corporate Disclosure on Cost of Equity Capital in Vietnam

The objective of the paper is to test the impact of corporate disclosure on the cost of equity capital for firms listed on Vietnam’s stock market. We use the Botosan (1997) scoring methodology and the residual income valuation model to measure disclosure level and the implied cost of equity capital. Our findings suggest that, taking into account other determinants, disclosure has a significant reducing impact on the cost of equity capital.

Relevância da informação contábil em empresas dos Brics e EUA

A busca por informações contábeis relevantes tem sido intensa pelos órgãos normalizadores nos últimos anos, os quais têm buscado estabelecer normas que tornem a informação contábil relevante e possa ser utilizada de forma segura no processo decisório, principalmente considerando as decisões relacionadas ao mercado de capitais. Nessa linha, James Ohlson propôs modelos de avaliação de empresas baseados em números contábeis. O objetivo deste estudo é verificar as diferenças na Relevância da Informação Contábil no mercado de capitais dos países Brasil, Rússia, Índia, China e África do Sul (BRICS) e Estados Unidos da América (EUA), a partir dos dados disponíveis nas Bolsa de Valores destes países, por meio dos modelos Residual Income Valuation (RIV) e Abnormal Earnings Growth (AEG) propostos por Ohlson (1995; 2005). Por meio da Regressão com Dados em Painel, concluiu-se que as variáveis de cada país apresentam comportamento diferente no tocante a influência das mesmas no mercado de capitais, pois além de apresentarem coeficientes distintos, houve extensa variação do R2, sendo 0,02 no Brasil, para o modelo AEG e 0,79 na China para o modelo RIV. Quanto à verificação de qual modelo (RIV ou AEG) melhor se adapta à realidade de cada país, observou-se que no Brasil e África do Sul o modelo AEG apresentou maior ajuste, já na Rússia e China o modelo RIV foi mais adequado, tanto para variáveis defasadas pelo Preço em t-1, quanto para as não defasadas, pois conta com R2 mais expressivo e valor mais baixo para Critério de Informação de Akaike. Para os EUA e Índia, para variáveis não defasadas, o AEG é o melhor modelo para Índia e RIV para os EUA. Já com variáveis defasadas, o resultado se inverte.

Are Top Management Networking Skills Valuable? An Empirical Investigation of US Companies in the Context of Residual Income Valuation Model

This study investigates the impact of networking skills on company value by using the residual income model. We examine U.S. companies that constitute Standard and Poor’s 1500 index for the period 2002-2015 and we provide evidence that networking skills are significant part of company value. The evidence is robust after taking account of endogeneity. This study links the value relevance concept with social capital and provides support to resource dependence theory and social exchange theory.

Inferring Aggregate Market Expectations from the Cross-Section of Stock Prices

Motivated by the residual income valuation model of Ohlson (1995), we introduce a new approach to forecasting market returns that combines the cross-section of dividends, earnings, and book values to explain current stock prices and extract aggregate expected returns. Our measure of market return expectations is strongly correlated with popular ex ante equity premium measures and business cycle variables. It portends a significant fraction of the time-series variation in stock market returns at horizons of one month to two years. Consistent with the theory on which our measure is based, the predictability that we uncover is particularly strong at longer return forecasting horizons, where it dominates that afforded by popular predictive variables, achieving an out-of-sample R2 of 12.6% at the annual horizon.

Can a Hybrid Method Improve Equity Valuation? Empirical Applications of Ohlson and Johannesson (2016)

We investigate whether combining the two principal valuation techniques – a price multiple model and a discounted model – can improve the quality of equity valuation. Specifically, we empirically implement the theoretical valuation model in Ohlson and Johannesson (2016), which we refer to as the OHJO model (or OHJO), as a hybrid of a price multiple model and a discounted model, and develop a novel way to estimate the model’s unique parameter – the normal forward P/E ratio. We find that our implementation produces intrinsic values that are more accurate and generally less biased, and that are better at explaining stock prices, than popular discounted models such as the Residual Income Valuation Model (RIV) and the Ohlson-Juettner Model (OJ), as well as price multiple models. OHJO’s superior valuation performance is robust in subsamples, and is more pronounced for slow growing, less risky, and larger firms. In addition, the implied cost of equity estimated from OHJO captures systematic risk and information asymmetry better than that from RIV and OJ. These results demonstrate the usefulness of a hybrid method for equity valuation and support the empirical validity of OHJO.

Behavioral Timing, Valuation and Postissue Performance of UK Initial Public Offerings

ABSTRACTUsing a sample of 1,926 UK initial public offerings (IPOs) launched from 1987 to 2007, this study introduces a new angle on testing the behavioral timing hypothesis in the context of UK IPOs via investigating relationships between the magnitude of IPOs misvaluation and postissue stock price and operating performance. IPO misvaluation is measured using (i) an intrinsic value of the firm estimated using residual income valuation model and (ii) intensity of IPO issuance activity. The findings show that stock price and operating underperformance in the postissue are directly linked to the degree of IPOs' misvaluation. Specifically, the stock price and operating performance are found to be significantly and robustly different between hot markets IPOs and cold market IPOs 3 years postissue. We also show that overvalued IPOs have lower long-run stock returns, but outperforming operating performance, than undervalued IPOs do. Our findings are broadly consistent with the behavioral explanations of the poor stock price and operating performance, supporting the U.S. results of Purnanandam and Swaminathan [2004] and Loughran and Ritter [2000].

The Use of Residual Income Valuation Methods by U.S. Sell-Side Equity Analysts

ABSTRACTWe investigate the use and performance of residual income (RI) valuation methods by U.S. sell-side equity analysts in a small-sample manner wherein we extract the rich details of analysts' RI valuations from their PDF reports over the period 1998–2013. We observe that RI valuations are much rarer than discounted cash flow (DCF) valuations, and that different RI and DCF valuations are sometimes provided by the same analyst for the same firm in the same report. We find that while some analysts build RI models around net operating income (RNOA-RI) and others around net income (ROE-RI), RNOA-RI valuations are optimistic to the same degree as DCF valuations and contain RNOAs that increase to an economically unlikely terminal year median of 27 percent. In contrast, analysts' ROE-RI valuations are unbiased when done in tandem with a DCF valuation, as are the DCFs that accompany them, and contain ROEs that decline over the forecast horizon to a more plausible terminal year median of 17 percent. We conclude that analysts' use of ROE-RI methods can lead to more sophisticated forecasts of economic fundamentals and equity valuations, especially when used in tandem with DCF.JEL Classifications: G12; G17; G32.

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.

Empirical estimation of the Residual Income Valuation Model: Profit-Making vs. Loss-Making firms

Empirical estimation of the Residual Income Valuation Model: Profit-Making vs. Loss-Making firms Walid Saleh Abstract This paper tests the empirical performance of different specifications of the residual income valuation model based upon the inflation-adjusted model of Gregory, Saleh, and Tucker (2005) that is consistent with the Walker's (1997, p 354) suggestion that historical cost accounting versions of the model be abandoned in favor of one based on deprival values. Overall, the paper concludes that the Ohlson (1995) specification appears to be the best model that explains stock prices relative to other specifications used in this paper. Full Text: PDF DOI: 10.15640/jfbm.v5n2a2

Who’s a major? A novel approach to peer group selection: Empirical evidence from oil and gas companies

AbstractThis study presents a novel approach to selecting comparable companies in equity valuation. While valuation multiples is probably the most common valuation method in practice, discounted cash flow and residual income valuation models are advocated by academics. A key aspect in valuation by multiples is peer group selection. In this paper, we examine the usefulness of econometric techniques in peer-group selection for the largest companies in the international oil and gas sector. Using Chow tests, we are able to identify firms with similar relationships between valuation multiples and relevant value drivers. These results of our study suggest that analysts and investors should, when carrying out valuations, be careful in selecting the companies that comprise the peer groups. Comparable company selection could be carried out using econometric techniques that select companies on the basis of similarities in the relation between financial information and market valuation, instead of being based purely...

Is the accuracy of stock value forecasting relevant to industry factors or firm-specific factors? An empirical study of the Ohlson model

This study develops a methodology to incorporate industry and firm-specific factors into the Ohlson (Contemp Account Res 11:661–687, 1995). Residual income valuation model (RIM) and applies a time- series approach instead of the cross-sectional regression models used by existing studies. This method provides neglected valuation information when analysts’ earnings forecasts are used. The results suggest that it improves the accuracy of stock value forecasting. The inclusion of the two factors increases the forecasting ability of RIM. Furthermore, the relative importance of the two factors varies across industries. Firm-specific factors are relevant to the accuracy of stock value forecasting for three large industries (finance and insurance, electronics, building, construction and materials), whereas industry factors play a dominant role in determining the accuracy for small industries (automobile and paper). These results imply that either industry or firm-specific factors serve as crucial determinants in stock value forecasting for the five industries. In practice, investors can consider one or both of the two factors when implementing RIM to forecast stock value.

Investor sentiment, accounting information and stock price: Evidence from China

This paper analyzes the mechanism behind the effects of investor sentiment and accounting information on stock price based on the residual income valuation model. Using data from China's A-share market, we construct the sentiment index and examine the sentiment effect from the perspective of the expected earnings growth and the required rate of return. Furthermore, we investigate the joint effect of sentiment and accounting information on stock price and highlight the asymmetric effect of investor sentiment and the moderating effect of information uncertainty. The empirical results show that investor sentiment can change both the expected earnings growth and the required rate of return, thus affecting the stock price. However, the sentiment effect during pessimistic period is evidently different from that when sentiment is relatively high, especially for the required rate of return. In addition, accounting information and investor sentiment can both explain the stock price. However, accounting information is more reliable for stocks with stable earnings, whereas investor sentiment has evident asymmetric effect on stock price and should receive more focus for stocks with high information uncertainties.

Equity Value as a Function of (eps1, eps2, dps1, bvps, beta): Concepts and Realities

This paper examines three basic equity valuation concepts: (1) residual income valuation (RIV); (2) in the spirit of Miller‐Modigliani, the irrelevance of a firm's dividend payout policy; (3) betas/CAPM, to quantify risk and capitalization factors. As a first cut, results show that RIV, concept (1), lacks empirical support while in contrast concepts (2) and (3) hold up reasonably well. To address (2) and (3) we develop a model where earnings and earnings growth determine value. This model supplants RIV because of its greater intuitive appeal and empirical support. A linear function of eps1, eps2, dps1 maps into stock prices and theory specifies the coefficients’ admissible magnitudes. Both the concepts of dividend payout irrelevance and risk (cost‐of‐equity per CAPM) restrict the coefficients. Bvps is value‐irrelevant, in both the analytical and empirical analyses. The latter can be viewed as a case study; it considers S&P500 firms at two points in time, and the data was hand‐collected in real time from a public website (Yahoo!Finance). This scheme ensures perfectly synchronized data and it usefully provides not only consensus forecasts but also real time betas. Overall, the paper contributes by developing valuation concepts and by showing how these can be evaluated empirically.

Equity Value as a Function of (eps1, eps2, dps1, bvps, beta): Concepts and Realities. Discussion of Ohlson and Johannesson

Ohlson and Johannesson (2016) examine how valuation models and model inputs help explain stock prices. In particular, they develop and test a new valuation model based on abnormal earnings growth (AEG). They also critique residual income valuation (RIV). The issue is important since the two valuation approaches play a central role in research and textbooks.

A Comparative Analysis of Accounting-Based Valuation Models

We empirically compare the reliability of the dividend (DIV) model, the residual income valuation (CT, GLS) model, and the abnormal earnings growth (OJ) model. We find that valuation estimates from the OJ model are generally more reliable than those from the other three models, because the residual income valuation model anchored by book value gets off to a poor start when compared with the OJ model led by capitalized next-year earnings. We adopt a 34-year sample covering from 1985 to 2013 to compare the reliability of valuation estimates via their means of absolute pricing errors ( MAPE) and corresponding t statistics. We further use the switching regression of Barrios and Blanco to show that the average probability of OJ valuation estimates is greater in explaining stock prices than the DIV, CT, and GLS models. In addition, our finding that the OJ model yields more reliable estimates is robust to analysts-based and model-based earnings measures.

Does the vector error correction model perform better than others in forecasting stock price? An application of residual income valuation theory

This paper employs a multi-equation model approach to consider three statistic problems (heteroskedasticity, endogeneity and persistency), which are sources of bias and inefficiency in the predictive regression models. This paper applied the residual income valuation model (RIM) proposed by Ohlson (1995) to forecast stock prices for Taiwan three sectors. We compare relative forecasting accuracy of vector error correction model (VECM) with the vector autoregressive model (VAR) as well as OLS and RW models used in the prior studies. We conduct out-of-sample forecasting and employ two instruments to assess forecasting performance. Our empirical results suggest that the VECM statistically outperforms other three models in forecasting stock prices. When forecasting horizons extend longer, VECM produces smaller forecasting errors and performs substantially better than VAR, suggesting that the ability of VECM to improve VAR forecast accuracy is stronger with longer horizons. These findings imply that an error correction term (ECT) of the VECM contributes to improving forecast accuracy of stock prices. Our economic significance analyses and robustness tests for different data frequency are in favor of the superiority of VECM estimator.