The Relation between Market Values, Earnings Forecasts, and Reported Earnings

Abstract

Recently, much of the research into the relation between market values and accounting numbers has used, or at least made reference to, the residual income model (RIM). Two basic types of empirical research have developed. The "historical" type explores the relation between market values and reported accounting numbers, often using the linear dynamics in Ohlson (1995) and Feltham and Ohlson (1995, 1996). The "forecast" type explores the relation between market value and the present value of the book value of equity, a truncated sequence of residual income forecasts, and an estimate of the terminal value at the truncation date. The analysis in this paper integrates these two approaches. We expand the Feltham and Ohlson (1996) model by including one- and two-period-ahead residual income forecasts. This can be viewed as the use of forecasts in the "historical" model to infer "other" information about future revenues from past investments and about future growth opportunities. Alternatively, it can be viewed as the use of historical data (and the assumed dynamics) in the "forecast" to develop forecasts beyond the truncation period. In either case, the result is in a model in which the difference between market value and book value of equity is a function of current residual income, one- and two-period ahead residual income forecasts, current capital investment and start-of-period operating assets. The existence of both persistence in revenues from current and prior investments and growth in future positive NPV investment opportunities leads us to hypothesize a negative coefficient on the one-period ahead residual income forecast and a positive coefficient on the two-period-ahead residual income forecast. Our empirical results strongly support our hypotheses with respect to the forecast coefficients.

JEL Classification: G12, M41