Valuation Errors Caused by Conservative Accounting in Residual Income and Abnormal Earnings Growth Valuation Models

The impact of conservative accounting in residual income valuation (RIV) and abnormal earnings growth (AEG) valuation modeling is investigated in this paper. Unconstrained and two types of constrained model specifications are evaluated regarding their ability to withstand biases in book values and earnings due to accounting conservatism. Given that the “clean surplus relation” holds and that the precision of forecasted accounting numbers is unaffected by the type of accounting principles, the unconstrained valuation models are – not surprisingly – found to be immune to conservatism. This does not hold for the constrained models, even though conservatism can be accommodated in these if the time-series specification of the conservative bias fulfils certain conditions. In a comparison between terminal value constrained models, the AEG model is found to be superior to the RIV model if the growth of the conservative bias in the terminal period is not too extreme. Comparing the information dynamics constrained models being proposed in Ohlson (1995) and Ohlson & Juettner-Nauroth (2005), the AEG model is potentially more accurate than the RIV model. However, in a company steady state setting with constant growth, there is no comparative advantage for the AEG model. Also, using the same set of forecasted accounting numbers in the information dynamics constrained RIV model as in the corresponding AEG model, the two models cannot be ranked.Abnormal earnings growth model; Accounting-based valuation; Conservative accounting; Financial analysis; Residual income model

Expected EPS and EPS growth as determinants of value

This paper develops a parsimonious model relating a firm’s price per share to, (i), next year expected earnings per share (eps), (ii), short term growth (FY-2 vs. FY.1) in eps, (iii), long-term (asymptotic) growth in eps, and, (iv), cost-of equity capital. The model assumes that the present value of dividends per share (dps) determines price, but it does not restrict how the dps-sequence is expected to evolve. All of these aspects of the model contrast sharply with the standard textbook approach, which equates the growth rates of expected dps and eps and fixes the growth rate and the payout rate. Though the constant growth model arises as a peculiar special case, the analysis in this paper rests on more general principles, including dividend policy irrelevancy. In addition to the valuation formula, a key result shows how one expresses cost-of-capital as a function of next-year expected eps and the two measures of growth in expected eps. This expression generalizes the text-book equation in which cost-of-capital equals dps-yield plus the growth in expected eps. 2 I