Opportunities Knocking: Residual Income Valuation of an Adaptive Firm

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.

Number of Pages in PDF File: 60

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

JEL Classification: D81, D46, M41, D92, D84, G12

Accepted Paper Series