Earnings Components, Accounting Conservatism and Equity Valuation
Peter F. Pope
London School of Economics
Xfi, University of Exeter
Review of Accounting Studies, Forthcoming
In this paper we address three issues in accounting-based equity valuation: (i) How are valuation parameters related to earnings persistence and accounting conservatism when earnings components aggregate, or add up, in valuation? (ii) What does aggregation of earnings components in valuation imply for abnormal earnings dynamics? and (iii) When is an earnings component irrelevant and core earnings the relevant construct for valuation? Assuming linear valuation, no-arbitrage, dividend irrelevance and clean surplus accounting, we show that when earnings components aggregate, valuation expressions and abnormal earnings dynamics are generalizations of the Ohlson (1995) model, incorporating simple adjustments for accounting conservatism. When core earnings is the relevant earnings construct, valuation expressions closely resemble the aggregation case, but core (abnormal) earnings replaces clean surplus (abnormal) earnings. We demonstrate that an earnings component can be irrelevant in valuation even when it is predictable.
Number of Pages in PDF File: 35
Keywords: Equity valuation, Earnings components, Accounting conservatism, Dividend irrelevance
JEL Classification: D46, G12, G35, M41
Date posted: February 27, 2005
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