Accounting Information, Capital Investment Decisions, and Equity Valuation: Theory and Empirical Implications

Posted: 3 Apr 1999

Multiple version iconThere are 2 versions of this paper

Date Written: November 1998

Abstract

This paper combines the framework of Feltham/Ohlson (1996) with endogenous investment decisions to re-examine the role of book value and earnings for valuation. The paper recognizes that current accounting data contains information useful for guiding operating decisions, and operating activity is what underlies the generation of cash flows. By considering a firm's rational investment behavior, a connection is established between the current state of operation and the future cash flow stream. The valuation function derived within this setting exhibits some interesting properties. It is shown that equity value is an increasing and convex function of earnings for any given book value. On the other hand, for a given level of earnings, equity value can be either increasing in, insensitive to, or decreasing in book value, depending on a firm's operating efficiency and/or growth potential. The model further explains cross-sectional variations in the significance of earnings versus book value in value determination and the "anomalous" association between stock prices and negative earnings. The effect of conservatism on the properties of accounting-based valuation function is also examined. The theoretical predictions of the model are generally consistent with the evidence reported in empirical studies. Implications for empirical research design are discussed.

JEL Classification: G12, M41

Suggested Citation

Zhang, Guochang, Accounting Information, Capital Investment Decisions, and Equity Valuation: Theory and Empirical Implications (November 1998). Available at SSRN: https://ssrn.com/abstract=158969

Guochang Zhang (Contact Author)

University of Hong Kong ( email )

KK Leung Building
Faculty of Business and Economics
Hong Kong
+852 3917 1076 (Phone)

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