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Conservative Accounting and Finite Firm Life: Why Residual Income Valuation Estimates Understate Stock Price

30 Pages Posted: 25 Oct 1999  

James N. Myers

University of Tennessee, Knoxville - College of Business Administration

Date Written: August 24, 1999

Abstract

Residual income (RI) valuation involves discounting estimated future RI over the entire life of the firm. Because accounting is conservative, price is higher than book value for the average firm, creating a large accounting gain (terminal income) at delisting for most firms. However, this terminal income is hidden from researchers because it is not included in archival databases such as Compustat. Although most valuation models posit infinite firm life, the median firm survives approximately ten years. Terminal income is omitted from recent archival valuation research and this omission creates biased valuation estimates. This explains why studies that use the residual income valuation model to estimate stock price understate stock price on average. The results suggest that the estimation of future price/book premiums is an important component of RI valuation and present a limitation of using accounting numbers to estimate firm value without reference to price.

JEL Classification: G12, G31, G32, M41

Suggested Citation

Myers, James N., Conservative Accounting and Finite Firm Life: Why Residual Income Valuation Estimates Understate Stock Price (August 24, 1999). Available at SSRN: https://ssrn.com/abstract=177208 or http://dx.doi.org/10.2139/ssrn.177208

James N. Myers (Contact Author)

University of Tennessee, Knoxville - College of Business Administration ( email )

Haslam Business Building
Knoxville, TN
United States

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