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Abstract:
This article solves a model that links earnings quality to the equity risk premium in an infinite-horizon consumption CAPM economy. In the model, risk-averse traders hold diversified portfolios consisting of a risk-free bond and shares of many risky firms. When constructing their portfolios, traders rely on noisy reported earnings and dividend payments for information about the risky firms. A new element of the model is an explicit representation of earnings quality based on reversing accrual errors that investors cannot observe. The model shows that earnings quality magnifies fundamental risk. Absent fundamental risk, poor earnings quality cannot affect the equity risk premium. Moreover, only the systematic (undiversified) component of earnings quality risk contributes to the equity risk premium. In contrast, all components of earnings quality risk affect earnings capitalization factors. The model ties together consumption-CAPM and accounting-based valuation research into one benchmark formula linking earnings quality to the equity risk premium and earnings capitalization factors.

Information quality, cost of capital, risk, return, diversification, earnings, valuation

Abstract:
Maintaining a competitive edge requires a firm to replace deteriorating business lines with new projects. Accordingly, part of a firm's value resides in its ability to exploit new opportunities. This article incorporates adaptation into Ohlson's residual income valuation framework and obtains a non-linear (convex) valuation formula. Although parsimoniously cast, the model makes two predictions which are consistent with phenomena reported in the empirical literature: earnings convexity and complementarity. Moreover, the Appendix introduces a new and powerful Equivalence Theorem. This Equivalence Theorem relates Modigliani-Miller dividend invariance to complementarity and earnings convexity in accounting-based valuation.

Residual Income Valuation, Modigliani Miller invariance, Non-Linearity, Adaptation

Abstract:
This article distinguishes earnings risk from prospective earnings variability, and identifies accounting systems in which earnings volatility is a reasonable proxy for risk. Then, it investigates the impact of earnings risk on reservation values within a Jorgensonian setting. Solving the optimal purchase and divestiture problems reveals that the buyer's and seller's respective reservation values (both generically denoted V) take the form

V = B(s) b + X(s) x

Here b is book value, x earnings, s parametrizes risk, and B and X are respectively the book value and earnings valuation multiples. In a world with bigger risk s, purchasers demand greater B and accept smaller X while, in contrast, divestors demand greater X and accept smaller B. This suggests that transactors with longer term stakes (buyers) emphasize book value while those with more immediate time horizons (sellers) fixate on earnings. The riskier the prospective earnings stream, the truer this thumb rule.

Earnings risk, Residual income valuation, Accounting-based real options

Abstract:
The concept of residual income has become popular in recent years due, in part, to the Ohlson 1995 article on residual income valuation. Since Ohlson assumed clean surplus accounting in that article, the concept of residual income and clean surplus accounting have become intimately linked in the literature. But is clean surplus accounting necessary for residual income valuation? Is there a formulation of residual income valuation that holds even when accounting violates the clean surplus relation? Yes. This article shows that accounting-based valuation builds naturally from a set of accounting-based "primitive difference" variables, not from the clean surplus relation. The primitive difference variables extend the notion of residual income. Using the primitive difference variables, this article specifies how value functions may be nonlinear in earnings and book value in settings with limited liability, accounting conservatism, or real options and still be dividend irrelevant.

Valuation, residual income, asset pricing, dividend irrelevancy, aggregation

Abstract:
Absent efficiency-cultivating judges, is selective litigation alone enough to drive the common law to efficiency? To address this question, the common law is viewed as an evolving network of precedents. Litigants nominate the most inefficient precedents for re-adjudication and judges modify these precedents haphazardly. I show that in equilibrium every precedent achieves and remains above (except when it is being relitigated) a threshold efficiency score. Above the threshold, any score is equally likely. Therefore, despite haphazard adjudication, selective litigation by itself is enough to drive the common law above a threshold efficiency level. However, haphazard adjudication fails to achieve perfect efficiency - the efficiency distribution above the threshold has nonzero width.

common law, evolution, learning, adaptation, networks

Abstract:
This article articulates how forward earnings are more accurate valuation attributes than trailing earnings. First, I show that, while linear accrual rules cannot achieve accurate trailing earnings-value relations in a setting with unobserved information, they can achieve accurate forward earnings-value relations. Second, I prove that, even when accrual rules are restricted so that forward earnings fails to be an exact valuation attribute, more-forward earnings are more accurate valuation attributes than less-forward earnings or trailing earnings. In conclusion, even under deficient accrual policies, more-forward earnings are more accurate valuation attributes - the more-forward, the more accurate.

Accruals, beliefs, earnings, forecasts, valuation

Abstract:
This article develops a consumption-based valuation model that treats earnings and cash flow as complementary information sources. The model integrates three ideas that do not appear in traditional valuation models: (i) earnings provide information about future shocks to cash flow; (ii) earnings contain indiscernible transient accruals; and (iii) investors use cash flow and earnings to make allocation and consumption decisions and set price. Accordingly, the quality of earnings affects production and consumption as well as price. Among other implications, the model reveals that a valuation coefficient is not just a capitalization factor; it is the product of a capitalization factor and a structural factor reflecting earnings quality and accounting bias.

information quality, production, CAPM, cost of capital, DCF, resource allocation

Abstract:
This article develops a consumption-based valuation model that treats earnings and cash flow as complementary information sources. The model integrates three ideas that do not appear in traditional valuation models: (i) earnings provide information about future shocks to cash flow; (ii) earnings contain indiscernible transient accruals; and (iii) investors use cash flow and earnings to make allocation and consumption decisions and set price. Accordingly, the quality of earnings affects production and consumption as well as price. Among other implications, the model reveals that a valuation coefficient is not just a capitalization factor; it is the product of a capitalization factor and a structural factor reflecting earnings quality and accounting bias.

earnings quality, CAPM, equity risk premium, DCF, resource allocation

Abstract:
This article examines Constantinides-strategy capital gains tax trading during earnings announcements in a Kyle trading market. Capital gains taxes discourage shareholders from selling after a runup. On the other hand, capital loss offsets encourage selloffs after a crash. Accordingly, prices are path dependent and not Martingale: after a runup they are sticky against bad news; after a crash, they resist good news. As the focus of information-based trading, earnings announcements provide a ready setting for exhibiting the interplay of these tax implications with price efficiency.

Earnings announcements; Tax trading; Tax arbitrage

Abstract:
Obtaining more accurate equity value estimates is the starting point for stock selection, value-based indexing in a noisy market, and beating benchmark indices through tactical style rotation. Unfortunately, discounted cash flow, method of comparables, and fundamental analysis typically yield discrepant valuation estimates. Moreover, the valuation estimates typically disagree with market price. Can one form a superior valuation estimate by averaging over the individual estimates, including market price? This article suggests a Bayesian framework for combining two or more estimates into a superior valuation estimate. The framework justifies the practice -- popular on Wall Street as well as in courtrooms and tax court -- of averaging over several estimates to arrive at a final point estimate.

value investing, financial statement analysis, equity valuation

Abstract:
Two new evolutionary game models are presented where ownership and trade emerge from anarchy as evolutionary stable strategies. In these models, ownership status provides an endogenous asymmetrizing criterion enabling cheaper resolution of property conflicts.

property, trade, evolutionary games, ownership, game theory, sociobiology, property rights

Abstract:
Two new evolutionary game models are presented where ownership and trade emerge from anarchy as evolutionary stable strategies. In these models, ownership status provides an endogenous asymmetrizing criterion enabling cheaper resolution of property conflicts.

Property, trade, evolutionary games, ownership, game theory, sociobiology, property rights

Abstract:
I describe recent developments in the rules governing registration and ownership of Internet and World Wide Web addresses or "domain names." I propose that elements of domain names are more similar to real estate than to trademarks and, therefore, it would be economically efficient to grant domain name owners stronger rights than those of trademark holders.

Internet, Domain names, Web addresses, cyberlaw, cyberspace, intellectual property

Abstract:
This article relates interim financial reporting frequency in a multiperiod Kyle framework to securities prices, trading volume, market liquidity, and analysts' information acquisition expenditures. The model supports conventional wisdom that more frequent interim reporting improves the information content of securities prices, reduces reporting day price volatility and trading volume, and enhances market liquidity. However, the model also suggests that more frequent financial reporting induces analysts to increase their redundant information acquisition expenditures, which may be socially wasteful.

Interim reporting frequency, earnings announcements, analysts

Abstract:
Prior to 1984, Delaware judges relied exclusively on the Delaware Block method - an appraisal formula based on trailing earnings and liquidation value - to price shares in shareholder litigation. In 1984, the Delaware Supreme Court changed the law to permit its judges to use any valuation method they deem appropriate. As a result, judges and litigants began switching away from the Block method and adopting forward-looking valuation techniques based on cash flow and earnings forecasts. While the use of forward-looking methods potentially improves valuation accuracy by incorporating forecast information, the use of forecasts allows more room for subjective manipulation. Did the adoption of forward-looking methods improve or reduce valuation accuracy in shareholder litigation? We address these questions using a comprehensive hand-collected sample of all Delaware corporate appraisal-remedy cases published between 1966 and 2002 in Lexis-Nexis. The sample identifies, on a case-by-case basis, the plaintiff's, the defendant's, and the judge's valuation methods and resulting valuation estimates. We show that the adoption of forward-looking valuation methods improves litigants' valuation accuracy on average.

equity valuation, earnings forecasts, Delaware, shareholder litigation

Abstract:
Is choice of incorporation state associated with differences in firms' fundamental attributes? We show that firms incorporated in Delaware are larger, younger, less profitable, more risky, spend more in R&D, and have larger Tobin's Q than non-Delaware U.S. firms. Furthermore, we show that, compared to non-Delaware firms, Delaware firms on average issue accounting statements that are more conservatively biased (thus biasing Daines' (2001) financial measures), and that Wall Street analysts issue more optimistic earnings growth projections for Delaware firms. Then we revisit Daines (2001), which suggests that Delaware-incorporated firms command a value premium over non-Delaware U.S. firms. While Daines' study controls for most of the important attributes of Delaware firms, it does not control for accounting bias and analysts' forecasts. Upon controlling for either one of these two attributes, the Delaware value premium disappears.

corporate law and finance, analysts' forecasts, accounting bias

Abstract:
In the Dueling Experts Game, adversarial experts strategically produce "good" or "bad" evidence to support their partisan testimony. Good evidence is probative while bad evidence has no evidential value. The new feature of this Game is that Judge sometimes erroneously identifies good evidence as bad evidence and vice versa. Along the Game's equilibrium path, each partisan expert produces only good evidence if it supports his side. When favorable good evidence is unavailable, an expert produces bad evidence to support his testimony. Hence, dueling experts always contradict one another. Despite their conflicting testimony, one of the experts invariably produces the available good evidence for Judge. Therefore, Judge always receives the available good evidence. A central result is that the quality of experts, including their ability to persuade judges using available good evidence, and the quality of judges - their ability to distinguish good from bad evidence - determine the accuracy of verdicts. Remarkably, the likelihood that experts are endowed with good evidence does not matter provided that this likelihood is not identically zero or one.

equity valuation, shareholder litigation, expert testimony, judicial error

Abstract:
This paper relates interim financial reporting frequency in a multiperiod Kyle framework to securities prices, trading volume, market liquidity, and analysts' information acquisition expenditures. The model supports conventional wisdom that more frequent interim reporting improves the information content of securities prices, reduces reporting day price volatility and trading volume, and enhances market liquidity. However, the model suggests that more frequent financial reporting induces analysts to increase their redundant information acquisition expenditures, which may be socially wasteful.

Abstract:
This article estimates the margin of safety for publicly traded companies. In addition to market price volatility, the model identifies three sources of fundamental risk: 1) risk that interim news may necessitate revision of an initial valuation estimate before profits can be taken; 2) uncertainty over the reliability of a value estimate; and 3) uncertainty over when market price will converge to the investor's value estimate. The model indicates that, while investors should demand margins of safety that are typically 10% to 25% of the share price, larger margins are justified for especially risky stocks.

margin of safety, value investing, idiosyncratic volatility, convergence

Abstract:
Why do 60% of target boards voluntarily solicit and pay for seemingly worthless 'Texas-wide' fairness opinions while 40% of their peers do not? Our new insight is that target boards speak to more than one shareholder generation through fairness opinions. We model fairness opinions as a cheap-talk game between a board of directors and public shareholders. In the core game, a board issues a fairness opinion to communicate with two shareholder generations: existing shareholders voting on the proposed sale of their shares, and potential after-market buyers who would buy if the present transaction fails. The game yields two distinct equilibria: one where the board issues no fairness opinions and one where Texas-wide fairness opinions emerge as equilibrium messages. The core game assumes that: (i) shareholders know the status of the board's private incentive; (ii) the proposed buyer sets a fixed bid equal to the ex ante expected value of the firm; and (iii) shareholders have no information about the target that the board does not have. We relax each of these three assumptions and prove that the conclusions drawn from the core game continue to hold. We conclude that three factors determine the width of fairness opinions: the board's private incentives; information asymmetry between the board and shareholders; and transactions costs incurred by after-market buyers if the current bid fails.

voluntary disclosure, board of directors, mergers and acquisitions, fairness opinions, cheap talk, shareholder generations

Abstract:
This article offers a model that articulates how the capitalization of costs affects contemporaneous earnings and the growth path of expected earnings. It makes three points. First, reported earnings under successful efforts are more price-relevant than earnings under full costing or full expensing. Second, whether conditional or unconditional, conservatism always enhances the growth rate of expected earnings. Third, independent of capitalization policy, the long-run expected earnings growth rate converges either to the long-run expected free cash flow growth rate or to the depreciation rate. Therefore, while capitalization policy affects the price relevance of earnings and short-run expected earnings growth, it does not affect long-run expected earnings growth.

earnings, growth, capitalization, R&D, real options, depreciation

Abstract:
How does the presence of a growth option affect expected earnings growth? This paper analyzes a firm with one growth option and an accrual accounting policy that, in the absence of a growth option, would equate accounting earnings to Hicksian earnings. Under this accounting policy, the presence of a growth option induces abnormal earnings growth and increases the long run growth rate of expected earnings. Further analysis links the long run growth rate of expected earnings to the option-exercise strategy and the expected lifespan of the option. Implications concerning the relationship between R&D investment, analysts' long run forecasts, and equity valuation are discussed.

growth, real options, earnings forecasts, earnings

Abstract:
This article characterizes controlling and minority share prices and optimal appraisal-remedy valuation rules in a rational expectations equilibrium. The model identifies a set of optimal judicial valuation policies that would motivate shareholders to make optimal investment and freeze-out choices, and identifies consequences of judicial valuation error. In particular, the model suggests that the share appraisal rule, under which minority shares are assessed a minority discount in freeze-out appraisals, would be more optimal than Delaware's pro rata doctrine, which forbids discounting of minority shares. Indeed, in accordance with the share appraisal rule and in contradiction with their own pro rata doctrine, Delaware courts frequently allow implicit discounts to minority shares in freeze-out appraisals. In summary, the model articulates why courts should not equate minority share value with market price. Consistent with this implication, Delaware courts have always uniformly rejected the notion that market price should be the sole determinant of appraisal value.

equity valuation, mergers and acquisitions, judicial valuation, judicial error

Abstract:
The estimates provided by discounted cash flow, the method of comparables, and market prices usually disagree. Combining two or more of these value estimates makes sense because every bona fide estimate provides information and because relying on one estimate ignores the information content of the others. How, then, should financial analysts combine different value estimates to form a more accurate estimate than that provided by any one method? Drawing from Bayesian decision theory, the Delaware Block Method, and forecasting research, this article suggests five rules of thumb for combining two or more value estimates into a superior value estimate.

Equity Investments: Fundamental Analysis and Valuation Models