Equity Valuation and Negative Earnings: The Role of Book Value of Equity
Posted: 26 Jan 1999
This study provides an explanation for the anomalous significantly negative price-earnings relation using the simple earnings capitalization model for firms that report losses. We hypothesize and find that including book value of equity in the valuation specification eliminates the negative relation. This suggests that the simple earnings capitalization model is misspecified and the negative coefficient on earnings for loss firms is a manifestation of that misspecification. Furthermore, we provide evidence on three competing explanations for the role that book value of equity plays in valuing loss firms. Specifically, we investigate whether the importance of book value in cross-sectional valuation models stems from its role as (1) a control for scale differences (Barth and Kallapur, 1996), (2) a proxy for expected future normal earnings (Ohlson, 1995; Penman, 1992), or (3) a proxy for loss firms' abandonment option (Berger, et al., 1996; Barth, et al., 1996; Burgstahler and Dichev, 1997). Our results do not support the conjecture that the importance of book value in cross-sectional valuation stems primarily from its role as a control for scale differences. Rather, the results are consistent with book value serving as a value-relevant proxy for expected future normal earnings for loss firms in general, and as a proxy for abandonment option for loss firms most likely to cease operations and liquidate.
JEL Classification: G12, M41
Suggested Citation: Suggested Citation