Residual Income Valuation: A New Approach Based on the Value-to-Book Multiple*

Abstract

This paper presents a new way to implement the residual income model (RIM) that improves the estimates of fundamental equity value of the firm over those of existing valuation models. RIM can be expressed as a form of the value-to-book (V/B) ratio. We decompose a firm’s V/B ratio into its industry V/B and firm-differential V/B, and then estimate separately these two components using the industry P/B (price-to-book) ratio and analysts’ earnings forecasts. We find that by incorporating the impact of both industry economic factors and conservative accounting, we improve on the predictability of existing valuation models, specifically that of Frankel and Lee (1998). We also find that our valuation measure predicts future returns more accurately for firms with high level of accounting conservatism. Finally, the results suggest that our valuation measure is a better predictor of future returns than value estimates based on traditional multiple methods.

Keywords: equity valuation, residual income model, value-to-book ratio, accounting conservatism

JEL Classification: M40