Aggregation, Dividend Irrelevancy, and Earnings-Value Relations

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.

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

JEL Classifications: M41, M44, G12, G31, G34, G35, D51, D52, H25

Accepted Paper Series