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Review of Quantitative Finance and Accounting

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01-04-2014 | Original Research

On the relevance of earnings components in valuation and forecasting

Author: Pengguo Wang

Published in: Review of Quantitative Finance and Accounting | Issue 3/2014

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Abstract

This paper articulates the links between relevance of an earnings component in forecasting (abnormal) earnings and its relevance in valuation in a nonlinear framework. The analysis shows that forecasting relevance does not imply valuation relevance even though valuation irrelevance is implied by forecasting irrelevance. Firstly, I consider an accounting information system where earnings components “add up” to a fully informative earnings number. Secondly, I analyze two accounting systems where a “core” earnings component is the relevant earnings construct for valuation and the second earnings component is irrelevant but may be predictable and relevant in forecasting other accounting items. I find that dividend displacement effect on earnings and the dynamics of individual earnings components are critical in this analysis.

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Other studies also document related non-linearities include Barth et al. (1998), Berger et al. (1996), and Subramanyam and Wild 1996).

Although prior literature challenges the empirical validity of the Ohlson (1995) model, it focuses on linear abnormal earnings information dynamics and corresponding linear valuation model. For example, Callen and Morel (2001) find that the extension of AR(1) to AR(2) process of abnormal earnings does not explain severe underestimation of market prices. Tsay et al. (2008) implement Ohlson (1995) model with ‘other information’ incorporating abnormal earnings information itself in a linear fashion. Higgins (2011) attempts to adjust for serial correlation in the residual income valuation model and improve the accuracy of forecasts of stock prices.

Stark (1997) shows that an earnings component is irrelevant in linear valuation if it has no predictive ability for other accounting items. Ohlson (1999) presents a linear model where a “transitory” earnings component is irrelevant in valuation if it is irrelevant in forecasting abnormal earnings and if it is, itself, unpredictable.

They argue that conservatism acts as an adjustment to the book value anchor in the abnormal earnings-based equity valuation.

Many contemporary policy debates surround the relevance of accounting items, including the treatment of unrealized gains and losses on marketable securities and financial instruments, changes in the cumulative foreign currency translation adjustment, and changes in the values of pension liabilities and assets (Dhaliwal et al. 1999; Chambers et al. 2007; Schipper 2007; Bamber et al. 2010).

Following the approach of Ohlson (1995, 1999), I could allow for an additional variable reflecting “other information” at time t that is not captured by the current accounting variables. As long as it is contemporaneously uncorrelated with the other variables included in the model, our main results would be unaffected.

For example, Ohlson (1995), Feltham and Ohlson (1995, 1996), Dechow et al. (1999), Barth et al. (1999, 2005) all start from linear abnormal earnings information dynamics.

By assuming A1, A2 and A3, Yee (2000) shows that book value b _t and dividend d _t must add in valuation of unrecorded goodwill. When ‘other information’ takes into account, we can rewrite valuation P _t = b _t + G(x _t ^a , b _t + d _t) + ϑ_t and the abnormal earnings dynamics as E _τ[x _τ+1 ^a ] + E _τ[G(x _τ+1 ^a , Rb _τ + x _τ+1 ^a )] = RG(x _τ ^a , b _τ + d _τ) + Rϑ_τ − E _τ[ϑ_τ+1].

Note that discussion in Ohlson (1999) is based on information set I ₀, which means ∂P _t/∂x _2t = ∂b _t/∂x _2t = 1, i.e., a dollar of earnings components adds a dollar of both market value and book value. The notion that an earnings component has no effect on next period expected earnings if and only if it is passed on as dividends holds in our information set I ₂ and VI-2 form valuation irrelevance with ∂P _t/∂x _2t = ∂b _t/∂x _2t = 0.

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Title: On the relevance of earnings components in valuation and forecasting
Author: Pengguo Wang
Publication date: 01-04-2014
Publisher: Springer US
Published in: Review of Quantitative Finance and Accounting / Issue 3/2014
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-013-0347-y

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