Relationships between Stock Prices and Accounting Information: A Review of the Residual Income and Ohlson Models. Scott Pirie* and Malcolm Smith**

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1 Relaionships beween Sock Prices and Accouning Informaion: A Review of he Residual Income and Ohlson Models Sco Pirie* and Malcolm Smih** * Inernaional Graduae School of Managemen, Universiy of Souh Ausralia ** School of Accouning, Finance & Economics, Edih Cowan Universiy School of Accouning, Finance and Economics & FIMARC Working Paper Series Edih Cowan Universiy Ocober 2005 Working Paper 0508 Correspondence auhor: Professor Malcolm Smih School of Accouning, Finance & Economics Edih Cowan Universiy 100 Joondalup Drive Joondalup WA 6027 Wesern Ausralia Phone: 61+ (8) Fax: 61+ (8)

2 Absrac As one of he main purposes of financial saemens is o provide relevan informaion for invesors, relaionships beween share prices and accouning variables have been widely researched. Early sudies focus mainly on earnings, bu aenion has urned in recen years o valuaion models ha include he book value of he equiy. Many of hese sudies cie he residual income model as heir heoreical base and, wih he growing emphasis on shareholder value, residual income measures are more commonly used in he business communiy o rack financial performance. Given such rends, his paper reviews he heoreical background of he residual income model and discusses resuls of empirical sudies ha use i. The sudy finds ha he wo main accouning variables can usually explain a subsanial par of he variaion in share prices, and i also idenifies a number of issues ha remain unresolved. These findings should be of ineres o oher researchers, and o managers and invesors who currenly use or are planning o use residual income o monior business performance. Keywords: Valuaion; residual income; Ohlson model

3 1. Inroducion I is generally acceped ha a basic objecive for mos commercial organisaions is o generae wealh. Firms may have differen policies on he disribuion of wealh bu, if hey fail o creae i in he firs place, hey are likely o have difficuly raising capial o suppor heir aciviies. Consequenly, he creaion of value is imporan no only for invesors bu also for hose who manage he firm. If a firm is publicly lised, is value o he owners can be derived from he share price. However, share prices end o flucuae coninually in response o informaion on general economic condiions as well as facors specific o he firm iself. Furhermore, many firms are no publicly lised and here may be no readily available price for heir shares. As a resul, managers usually rely on less volaile figures from he accouning sysem o measure financial performance and invesors have he published accouns o assis hem wih sock selecion. Consequenly, relaionships beween accouning informaion and share prices are of considerable pracical ineres. Early research in his field focused mainly on earnings, bu here has been a rend in recen years o include equiy book value as an addiional variable and o adop he residual income model as he heoreical framework. Furhermore, wih an increasing focus on value creaion, residual income measures have become more widely used by he business communiy as indicaors of financial performance. Given such rends, i is relevan o ask how well hey perform. This paper addresses ha quesion by considering he resuls of empirical sudies ha examine relaionships beween share prices and accouning variables in equiy markes around he world. 2. Valuaion Theory and Models I is well esablished in he heory of finance ha he economic value of an asse can be deermined by discouning he expeced benefis o he owner over he holding period a he opporuniy cos of capial. This sandard approach o valuaion is covered in Williams (1938), one of he earlies exs on invesmen heory, and i has is roos in he ne presen value rule commonly used o evaluae capial projecs. However, when his rule is applied o he firm as

4 2 a whole, he sream of benefis o be discouned can be defined in a number of differen ways and his leads o alernaive versions of he same basic model. 2.1 Dividend Discoun Model The mos direc approach o valuing shares defines he benefis o he owners as he dividends paid during he holding period plus he proceeds received from selling he shares a he end of ha period. However, when he shares are sold, he relevan price will be deermined by discouning he cash flows he new owner expecs o receive during he subsequen holding period. Consequenly, if i is assumed ha markes are efficien and he firm is a going concern wih an indefinie life, i can be shown by successive subsiuion ha he curren price of he shares P 0 can be calculaed by discouning he sream of all fuure dividends. This is shown in he following formula: = = (1 + E [ d ] 0 P 0 (1) 1 E0[ r ]) E 0 [.] is he expeced value of he variable concerned, condiional on he informaion available a he ime 0; d is he dividend paymen; and r is he opporuniy cos of capial applicable o he cash flows ha occur a ime. Equaion (1) is a general version of he dividend discoun model found in mos exs on corporae finance. However, while he model is sound in heory, i can be difficul o apply because i involves esimaing dividends and discoun raes for an infinie period of ime. As a resul, empirical sudies and pracical applicaions generally assume a simplified paern of dividend growh and a consan discoun rae. For example, if dividends are consrained o grow a a consan rae g for he remaining life of he firm, he general model can be reduced o he following expression: d 0 (1 + g) P0 = (2) r g This is he known as he consan growh dividend discoun model, and is usually aribued o Gordon (1962). A necessary assumpion is ha he consan expeced growh rae g is lower

5 3 han he consan discoun rae r. Oherwise, he series of cash flows will no converge o a finie soluion. Damodaran (1996) describes several alernaive versions of he model ha relax he consrain of consan perpeual growh by dividing he remaining life of he firm ino wo or more sages wih differen growh raes. These can accommodae more realisic paerns han consan perpeual growh, bu esimaing he dividend sream sill remains problemaic because dividends are largely discreionary. Indeed, firms wih high growh opporuniies may pay no dividends a all. Furhermore, Miller and Modigliani (1961) have shown ha, in a world wihou axes and ransacion coss, he value of a firm is unaffeced by he expeced paern of dividend paymens. This gives rise o wha Penman (1992) calls he dividend conundrum. Share prices depend on expeced dividend sream, bu he paern of dividends acually paid provides no useful informaion because i is largely discreionary. Moreover, dividends are no a direc measure of business performance because hey reflec decisions on he disribuion of wealh raher han operaing decisions ha affec is creaion. As a resul, considerable effors have been made o link share prices o earnings and oher variables ha are more direcly relaed o he process of value creaion. 2.2 Residual Income Model Several auhors such as Preinreich (1938), Edwards and Bell (1961) and Peasnell (1982) have shown ha he dividend discoun model can be ransformed o express he economic value of he equiy in erms of accouning book value and abnormal earnings, raher han dividends. In his conex, abnormal earnings x a are defined as normal earnings x less a charge for he cos of he equiy capial as follows: a x x r y (3) 1 where r is he cos of equiy and y is he equiy book value. Abnormal earnings are herefore similar o he residual income measure found in Solomons (1965), and oher pars of he

6 4 managemen accouning lieraure. They represen earnings in excess of a normal rae of reurn. A necessary condiion for equivalence of he dividend and accouning versions of he general model is he clean surplus or comprehensive income relaion. This requires ha accouning earnings include all changes in equiy book value excep ransacions wih he owners, and i can be saed as follows: y y 1 + x d (4) Here, d is dividends broadly defined o cover all ransacions wih he owners including new issues and repurchases of shares. Using he definiion of abnormal earnings and he clean surplus ideniy described in equaions (3) and (4), dividends can be expressed in erms of abnormal earnings and equiy book value as follows: d a = x + 1+ r) y 1 ( y (5) Subsiuing his in he dividend discoun model shown in equaion (1), assuming markes are efficien, and ha he discoun rae is consan over ime, he curren price of a share can be expressed in erms of accouning variables as follows: E [ x + (1 + r) y y ] a 0 1 P 0 = (6) = 1 (1 + r) Wih he furher assumpion ha E [ y ] (1 + ) r 0 as, his can be simplified o: 0 a E [ x ] P 0 = y0 (7) r) + 0 = (1 + 1 This is he residual income model, and i saes ha he curren share price or economic value of he equiy is equal o he curren book value of he equiy plus he presen value of all

7 5 fuure residual income or abnormal earnings. I should be noed ha he model does no require curren values of accouning variables o conform o he clean surplus relaion. I only requires ha esimaed fuure values be calculaed on his basis. Anoher noable feaure of he residual income model is ha i holds regardless of he accouning policies used o value he asses and measure he periodic income. In fac, any se of accouning rules can be applied as long as he clean surplus relaion is observed in esimaing fuure values, and as long as he presen value erm covers he whole of he remaining life of he firm. Differen accouning policies are likely o change he relaive size of he book value and residual income componens bu, as long as he clean surplus relaion holds and he presen value erm covers he remaining life of he firm, he oal economic value of he equiy will remain unchanged. On he oher hand, while he assumpions of he residual income model ensure ha he oal economic value remains he same regardless of he accouning policies adoped, he value creaed in individual ime periods will depend on he paricular measuremen rules applied. Consequenly, he division of oal economic value beween curren book value and fuure residual income will depend on he accouning policies adoped. In paricular, conservaive accouning policies ha undersae he curren book value of he asses will resul in relaively higher values for fuure earnings and residual income. 2.3 Ohlson Model One of he main aracions of he residual income model for researchers is ha i provides a sound heoreical link beween share prices and he wo summary accouning variables ha is consisen wih he radiional dividend discoun model. On he oher hand, like he dividend discoun model iself, he residual income model can be difficul o apply because i requires esimaes for an indefinie period of ime. Therefore, o make he models operaional, simplifying assumpions usually have o be made abou relaionships beween curren and fuure values. As menioned earlier, he general dividend discoun model is ofen simplified by assuming dividends will coninue o grow a a consan rae for he remaining life of he firm. A similar assumpion could be made for residual income as well, bu i seems an unlikely

8 6 scenario as firms wih abnormally high earnings usually arac compeiion ha reduces reurns over ime o a more normal level. I is more likely ha abnormally high earnings will be a emporary phenomenon and, wih his in mind, Ohlson (1995) proposes a model in which hey evolve according o he following auo-regressive process: x v a a + 1 = x + v + ε1 + 1 ω (8) + 1 = v + ε 2+ 1 γ (9) Here ω and γ are consan persisence parameers; ν is informaion, oher han curren abnormal earnings, ha is useful in predicing fuure abnormal earnings; ε 1 and ε 2 are random disurbance erms wih consan variance and zero mean. I is also assumed ha he persisence parameers ω and γ remain consan wihin a range beween zero and one so ha he process defined by equaions (8) and (9) will ypically resul in abnormal earnings ha decline over ime. Ohlson goes on o show ha, given he dynamics specified above, he residual income model can be reduced o a linear combinaion of curren book value, curren abnormal earnings and oher value relevan informaion as follows: a P y + α 1 x + α 2 = v (10) In his case, he coefficien on abnormal earnings α ω ( R ) and he coefficien on 1 = f ω oher informaion α R ( R ω)( R ) where R f is one plus he risk free rae, as risk neuraliy is assumed. 2 = f f f γ Subsiuing from he definiion of abnormal earnings and he clean surplus ideniy shown in equaions (3) and (4), Ohlson obains a furher expression for he price or marke value of he equiy in erms of curren book value, curren earnings, curren dividends and oher value relevan informaion, as follows: = ( + ϕ + α v (11) P 1 k) y k( x d ) 2

9 7 In his case, he coefficien k ( R 1) α1 = ( R 1) ω ( R ω), and he coefficien ϕ = f = f f f R f ( R 1). Expressed in his form, he Ohlson model can be viewed as a weighed average of a book value and an earnings model, wih appropriae adjusmens for dividends and oher value relevan informaion ha is no ye refleced in he accouns. As before, he dividends variable d is broadly defined o include oher ransacions wih shareholders, such as share issues and repurchases. A paricular aracion of he Ohlson model for empirical researchers is ha, unlike he basic residual income model ha requires esimaes of fuure abnormal earnings, he linear dynamics incorporaed in he Ohlson framework allows price o be expressed in erms of curren variables. Furhermore, he model goes beyond a general funcional relaionship o predic he sign and range of values for he respecive coefficiens. On he oher hand, like any oher model, he Ohlson framework has limiaions. Firs of all, he model refers o he individual firm and does no predic ha he parameers are he same for all firms (alhough his is ofen implied in cross-secional sudies). Secondly, he variable ha represens oher value relevan informaion is no specifically defined and herefore difficul o es. In fac, empirical sudies ofen omi i wih he implici assumpion ha i can be absorbed enirely in he inercep and random error erms. Thirdly, while he dynamics incorporaed in he Ohlson framework are plausible, hey are only one of many possible ways in which residual income could evolve over ime. Neverheless, while i has limiaions, he model has made a significan conribuion o empirical research as i provides a sound heoreical link beween share prices and accouning informaion ha was previously missing. 3. Empirical Sudies The erm marke based accouning research has been used by several auhors, including Lev and Ohlson (1982) and Walker (1997), o describe he body of lieraure ha deals wih relaionships beween marke prices and accouning informaion.

10 8 Mos of he early empirical sudies in his field focus on earnings and are usually concerned wih he response coefficien ha relaes earnings o reurns raher han he explanaory power of accouning informaion for shares prices or value. However, in a review of earnings research, Lev (1989) noes ha earnings are generally found o have very low explanaory power, and he suggess ha his cass doub on he pracical value of repored earnings. While here is evidence ha earnings convey informaion ha helps form opinions abou securiy prices, he earnings figures hemselves have limied value because heir relaionship o prices is generally weak and unsable over ime. Lev suggess his could be due o bias inroduced by accouning rules, and he advocaes a shif in research focus away from he informaion conen of accouning variables owards he rules ha deermine hem. In anoher review of he relevan lieraure, Penman (1992) claims ha much of he empirical work in marke based accouning research has been misdireced in aking an informaional perspecive ha assumes accouning variables only affec share prices if hey provide new informaion. He advocaes ha here should be a reurn o fundamenals and a swich o a measuremen perspecive ha views accouning numbers as useful deerminans of asse values. Penman also mainains ha radiional fundamenal analysis and accouning pracices have lacked he heoreical foundaions required for rigorous economic analysis. However, he adds ha he work of Ohlson has been a significan breakhrough in his respec. The quesion arises, however, of how well residual income models can explain variaions in share prices. Several researchers have addressed his poin, and some of he more significan sudies are discussed in he following secions. The firs group explores he explanaory power of he models under differen ses of accouning rules. The second focuses on idenifying variables oher han earnings and book value ha may form par of he oher informaion in he heoreical framework. Finally, a number of sudies are discussed ha do no fall nealy ino eiher o he previous wo caegories. 3.1 Effec of Differen Accouning Rules Wih a view o examining he effecs of inernaional differences in accouning rules, Frankel and Lee (1998) explore relaionships beween share prices and accouning variables using daa from 20 counries ha include Ausralia, Japan, Souh Korea and Thailand. They use he general residual income model shown in equaion (7) ogeher wih repored book

11 9 values and consensus earnings forecass o calculae an esimaed value of he shares in individual companies. This value esimae is hen included as an explanaory variable ogeher wih curren book value and curren earnings in a model ha follows he version of he Ohlson model shown in equaion (11). The explanaory power of he model is high, 88% for he US and 72% for he oher counries combined. The sudy also finds ha he value esimae based on consensus earnings forecass is highly significan in all 20 counries, and ha i consisenly dominaes curren earnings and book value in explaining variaions in share prices. Furhermore, he coefficiens on he value esimaes are relaively sable over ime ranging from 0.67 in Norway o 2.56 in Ialy suggesing some consisency in relaionships beween share prices and he value esimaes under differen accouning regimes. The auhors use counry-specific discoun raes o calculae heir value esimaes, bu conclude ha mos of he explanaory power of he esimae can be aribued o he use of consensus earnings forecass raher han varying discoun raes. They go on o sugges ha he discouned residual income model could be an inegral par of a broad soluion o problems of inernaional accouning diversiy ha goes beyond he harmonisaion of sandards. Their reasoning is ha, in heory a leas, value esimaes based on his model do no depend on he paricular accouning rules adoped in published financial saemens. King and Langli (1998) examine relaionships beween share prices and he wo main accouning variables wih daa from Germany, Norway and he Unied Kingdom. They selec hese hree counries because he accouning sysems are considered quie differen, paricularly in heir degree of conservaism and he exen o which he accouning rules deviae from he clean surplus relaion. The auhors esimae a model ha links share prices o equiy book value and curren earnings in accordance wih equaion (11), and also esimae wo resriced models ha express share prices as a funcion of eiher equiy book value or earnings alone. They find ha book value and earnings are boh significanly relaed o share prices in all hree counries, and ha he wo variables combined have explanaory power of abou 70% in he Unied Kingdom, 60% in Norway and 40% in Germany. The auhors conclude ha hese findings are consisen wih he differences in he accouning sysems of he hree counries. They also find ha he incremenal and relaive explanaory power of he wo variables differ over ime and beween counries, wih book value explaining more han earnings in Germany and Norway bu less han earnings in he Unied Kingdom. The auhors noe however ha, in his case, he resuls are no consisen wih differences in conservaism and violaions of he clean surplus relaion embedded in he accouning rules. Finally, resuls

12 10 wih an exended model ha includes realised earnings for he following four years as proxies for expeced earnings show ha hese addiional variables explain lile of he variaion in marke prices no already explained by curren book value and earnings. In anoher sudy of inernaional accouning differences, Graham and King (2000) examine relaionships beween share prices and accouning variables in Indonesia, Souh Korea, Malaysia, he Philippines, Taiwan and Thailand. Their regression model relaes share prices o curren book value and curren residual income in accordance wih equaion (10) and hey find ha he coefficiens on boh hese variables are saisically significan in all six counries. They also find ha he explanaory power of he model varies significanly beween counries, ranging from a low of 24% in Taiwan o 55% in Thailand and 90% in he Philippines alhough, in his case, he sample size is relaively small. Their evidence suppors he view ha more srongly conservaive accouning informaion is less value relevan. They also find ha he incremenal explanaory power of book value is higher han ha of residual earnings in all six counries. Violaions of he clean surplus relaion such as revaluaion of asses and immediae wrie-offs of goodwill have he expeced effec on he value relevance of book value bu he effec on he value relevance of residual earnings is less clear. 3.2 Value Relevance of Oher Variables In a sudy o explore he marke valuaion of research and developmen expendiure in he Unied Kingdom, Green, Sark and Thomas (1996) adop a regression model based on he version of he Ohlson model shown in equaion (10). However, hey formulae i wih he marke-o-book premium (share price less equiy book value) as he dependen variable, and curren residual income as he main explanaory variable. The auhors hen add curren expendiure on research and developmen as a second explanaory variable ha can be considered as a par of oher value relevan informaion variable in he heoreical model. They go on o include a number of conrol variables such as curren adverising expendiure, marke share, capial srucure, and he variance of marke reurns as a measure of risk ha can also be considered as par of oher value relevan informaion. The auhors find ha residual income has significan explanaory power for he marke-o-book premium bu he evidence on research and developmen expendiure is mixed. The oher conrol variables have almos no effec on he explanaory power of he model and have lile effec on he inference ess.

13 11 Rees (1997) adops he version of he residual income model shown in equaion (11) as his heoreical framework in a sudy ha examines he impac of dividends, deb and invesmen expendiure on he marke value of a large sample of indusrial and commercial firms in he Unied Kingdom. He finds ha he wo summary accouning variables are highly significan in boh he pooled and annual regressions, alhough he coefficiens hemselves vary over ime. Rees hen goes on o explore he effec of dividends, deb and capial invesmen. He does his by decomposing earnings ino dividends and reained earnings, by re-saing book value as oal capial less oal deb, and by including he annual expendiure on fixed asses as an addiional explanaory variable. The resuls of he sudy show ha earnings disribued as dividends have a larger impac on value han earnings reained wihin he firm and ha, when dividends are included, he overall explanaory power of he model increases from 54% o 60%. There is also evidence ha capial expendiure is posiively relaed o marke value, bu here is inconsisen evidence on he value relevance of deb. Many sudies ciing Ohlson (1995) as heir heoreical framework include book value and earnings as explanaory variables in line wih equaion (11), bu relaively few include dividends or he variable ha represens oher value relevan informaion. However, in a sudy wih Unied Saes daa, Hand and Landsman (1998) include boh dividends and ne capial conribuions in addiion o he wo main accouning variables and use his model o es differen predicions ha arise from wo common assumpions abou oher value relevan informaion. Their model wih indusry fixed effecs explains abou 80% of he variaion in share prices. They also find ha, if oher value relevan informaion is se o zero as implied by empirical models ha omi i, he sign of he coefficien on dividends is reliably posiive when he heory predics i should be negaive. Alernaively, if realised earnings for he following year are included as a proxy for expeced earnings on he assumpion ha he oher informaion impacs fuure residual income hrough he linear informaion dynamics proposed by Ohlson, he sign of earnings coefficien is opposie o he heory. Hand and Landsman conclude ha neiher of hese assumpions cleanly fis he daa and hey sugges ha an explanaion for he posiive relaionship wih dividends could be ha, conrary o assumpions in he heoreical model, dividends provide informaion ha is useful for predicing fuure residual income. Consisen wih his explanaion, hey find ha larger dividends are associaed wih higher fuure residual income, especially for firms ha are currenly making losses.

14 Oher Sudies Moivaed by claims ha changes in he economy have caused hisorical-cos financial saemens o lose relevance over ime, Collins, Maydew and Weiss (1997) invesigae changes in he value relevance of earnings and book value in he Unied Saes over a period of fory years. Ciing he residual income model as heir heoreical base, he auhors esimae a regression model ha links share prices o equiy book value and earnings in accordance wih equaion (11). They find ha, conrary o claims in he professional lieraure, he value relevance of earnings and book value combined has acually increased slighly in he pas fory years. The auhors go on o esimae wo resriced versions of he model wih book value and earnings respecively as he sole explanaory variable, and use he resuls o calculae he incremenal explanaory power of each. They find ha, while he incremenal explanaory power of earnings has declined over ime, i has been replaced by an increase in he incremenal explanaory power of equiy book value. The auhors sugges a number of explanaions for his shif including an increase in ransiory componens of earnings, an increased frequency of negaive earnings, an increased proporion of smaller firms, and an increase in he proporion of firms wih a high inensiy of inangible asses. The evidence suggess ha hese facors can explain much of he shif. Barh, Beaver and Landsman (1998) examine he predicion ha he relaive roles of book value and earnings depend on he financial healh of he firm. Using bond raings as a measure of financial healh and wo samples of daa from he Unied Saes, hey esimae regression models linking marke value wih book value and earnings in accordance wih equaion (11). The firs sample consiss of firms ha subsequenly file bankrupcy, and he second includes firms in various saes of financial healh. The resuls confirm he predicion ha, as he healh of he firm declines, he relaive explanaory power of book value increases and he explanaory power of earnings declines. The auhors also examine a furher predicion ha he explanaory power of he earnings and book value variables varies sysemaically across indusries, according o he relaive imporance of inangible asses. Once again, he resuls suppor heir predicion. In indusries such as pharmaceuicals where inangible asses are more imporan, earnings have more explanaory power. In indusries such as financial services where inangible asses are less imporan, book values have more explanaory power. Their findings are robus o he inclusion of several conrol variables such as indusry

15 13 secor, firm size, reurn on equiy, negaive raher han posiive earnings, and volailiy of marke reurns. In a broad empirical assessmen of he Ohlson model, Dechow, Huon and Sloan (1999) noe ha is disinguishing feaure is he linear informaion dynamics linking expeced residual income wih currenly available informaion. They develop a number of regression models based on equaion (10) and (11) wih alernaive values of he persisence parameers, and hey esimae hese models wih daa from he Unied Saes. Their sudy finds ha models based on he Ohlson framework are a reasonable fi for he empirical daa, wih explanaory power in he range of 40% o 60%. However, hey also find ha hey show only a minor improvemen over a model ha capialises in perpeuiy earnings esimaes for he following year. The auhors sugges ha a possible explanaion for his could be ha invesors overweigh informaion in earnings esimaes, and underweigh informaion in he curren accouning variables. Neverheless, hey conclude ha he Ohlson model has a useful role o play in empirical research, because i provides a unifying framework for valuaion sudies ha have previously used accouning informaion o explain share prices wihou a sound heoreical base. Furhermore, he model highlighs assumpions ha oher models implicily make abou relaionships beween accouning variables and fuure residual income. Finally, i provides a solid plaform on which subsequen research can build. 4. Summary and Conclusion I is well esablished in he heory of finance ha he value of an asse can be deermined by discouning he expeced benefis o he owner over he holding period a he opporuniy cos of capial. Applying his concep o shares in a going concern leads o he dividend discoun model, which has become a sandard mehod of valuing shares. However, while his model is sound in heory, i can be difficul o apply in pracice because i involves esimaing fuure dividends for he remaining life of he firm. I is also difficul o apply he model o fas-growing firms ha reain mos of heir earnings and disribue lile or nohing in he form of dividends for subsanial periods of ime. For reasons like hese, considerable effors have been made o develop valuaion models ha link share prices o variables oher han dividends ha are more direcly relaed o he operaions of he firm. One possible approach is o discoun he free cash flow raher han he

16 14 dividend sream o esimae he oal value of he firm. The value of he deb can hen be deduced o deermine he value of he equiy. An alernaive approach is o focus on accouning variables, as hey are readily available and radiionally used o measure financial performance. Early developmens focused mainly on earnings bu aenion has urned in recen years owards models ha also include he equiy book value. These are usually based on he concep of residual income or abnormal earnings bu, while hey link value wih accouning variables raher han dividends, hey sill require esimaes of variables for he remaining life of he firm. To ackle his problem, Ohlson (1995) assumes ha residual income evolves according o an auo-regressive process and his enables him o develop a model ha can be expressed enirely in erms of currenly available daa. The Ohlson model has been adoped as he heoreical framework for a number of sudies ha explore he value relevance of accouning variables under differen circumsances. These generally find ha earnings and book value ogeher have considerably more explanaory power han eiher variable alone, and ha he explanaory power varies in differen accouning regimes. However, in many cases, a significan par of he variance remains o be explained and may be aribued in par o he variable in he heoreical model ha represens oher value relevan informaion. Wih his in mind, several sudies have esed he value relevance of variables oher han book value and earnings wih mixed resuls. There is also evidence ha residual income does no necessarily evolve according o he linear dynamic process assumed by Ohlson. These findings sugges ha he residual income model, and he Ohlson version in paricular, form a useful framework for exploring empirical relaionships beween share prices and accouning figures. They also sugges ha accouning-based measures used by invesors or business managers o esimae value or value creaion are likely o be more effecive if hey focus on boh earnings and book value raher han on one or oher of he main variables alone. Finally, here are opporuniies for furher research o idenify variables oher han earnings and book value ha have significan explanaory power, and o explore he empirical fi of alernaive ime-series processes linking fuure residual income wih daa ha is currenly available. In his conex, he residual income and Ohlson models can provide a sound heoreical base for such furher research.

17 15 References Barh, M.E., W.H. Beaver and W.R. Landsman (1998), "Relaive Valuaion Roles of Equiy Book Value and Ne Income as a Funcion of Financial Healh", Journal of Accouning and Economics, 25, pp Collins, D.W., E.L. Maydew and I.S. Weiss (1997), "Changes in he Value-Relevance of Earnings and Book Values over he Pas Fory Years", Journal of Accouning and Economics, 24, pp Damodaran, A. (1996), Invesmen Valuaion: Tools and Techniques for Deermining he Value of any Asse, John Wiley & Sons. Dechow, P.M., A.P. Huon and R.G. Sloan (1999), "An Empirical Assessmen of he Residual Income Valuaion Model", Journal of Accouning and Economics, 26, pp Edwards, E.O. and P.W. Bell (1961), The Theory and Measuremen of Business Income, Berkeley, Universiy of California Press. Frankel, R., and C.M.C. Lee (1998), Accouning Diversiy and Inernaional Valuaion, Working Paper, Universiy of Michigan and Cornell Universiy. Graham, R.C. and R.D. King (2000), Accouning Pracices and he Marke Valuaion of Accouning Numbers: Evidence from Indonesia, Korea, Malaysia, he Philippines, Taiwan and Thailand, The Inernaional Journal of Accouning, Vol. 35, No. 4, pp Gordon, M.J. (1962), The Invesmen, Financing and Valuaion of he Corporaion, Irwin. Green, J.P., A.W. Sark and H.M. Thomas (1996), "UK Evidence on he Marke Valuaion of Research and Developmen Expendiures", Journal of Business Finance and Accouning, 23 (2), pp Hand, J.R.M., and W.R. Landsman (1998), "Tesing he Ohlson Model: v or no v, ha is he Quesion", Working Paper, Universiy of Norh Carolina - Chapel Hill. King, R.D. and J. Langli (1998), Accouning Diversiy and Firm Valuaion, The Inernaional Journal of Accouning, Vol. 33, No. 5, pp Lev, B. and J.A. Ohlson (1982), "Marke-Based Empirical Research in Accouning: A Review, Inerpreaion, and Exension", Journal of Accouning Research, Vol. 20, Supplemen, pp Lev, B. (1989), "On he Usefulness of Earnings and Earnings Research: Lessons and Direcions from Two Decades of Empirical Research", Journal of Accouning Research, Vol. 27, Supplemen, pp Miller, M. and F. Modigliani (1961), "Dividend Policy, Growh and he Valuaion of Shares", Journal of Business, Ocober, 34, pp

18 16 Ohlson, J.A. (1995), "Earnings, Book Values and Dividends in Equiy Valuaion", Conemporary Accouning Research, Vol. 11, No. 2, Spring, pp Peasnell, K.V. (1982), "Some Formal Connecions beween Economic Values and Yields and Accouning Numbers", Journal of Business Finance and Accouning, 9,3, pp Penman, S.H. (1992), "Reurn o Fundamenals", Journal of Accouning, Audiing and Finance, Spring, pp Preinreich, G. (1938), "Annual Survey of Economic Theory: The Theory of Depreciaion", Economerica, 6, pp Rees, W.P. (1997), "The Impac of Dividends, Deb and Invesmen on Valuaion Models", Journal of Business Finance and Accouning, 24, (7) & (8), pp Solomons, D., (1965), Divisional Performance: Measuremen and Conrol, Financial Execuives Insiue Research Foundaion. Walker, M. (1997), "Clean Surplus Accouning Models and Marke-based Accouning Research: A Review", Accouning and Business Research, Vol. 27, No. 4, pp Williams, J.B. (1938), The Theory of Invesmen Value, Harvard Universiy Press.

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