When Capital Follows Profitability: Non-Linear Residual Income Dynamics
75 Pages Posted: 27 Dec 2000
Date Written: 15 November 2000
Economic reasoning suggests that capital follows profitability. This study introduces into residual income valuation "capital follows profitability" investment dynamics whereby capital investments are guided by the profitability of underlying investment opportunities. These investment dynamics predict convex versus linear relations between future and current residual income, with slope and convexity dependent on investment opportunity. We test these predictions against the linear information dynamics (LID) proposed by Ohlson (1995) and Feltham and Ohlson (1996), with supportive results. These findings point the way to further development of links between firm value and the economics of value creation.
Keywords: Residual Income, Valuation, Linear Information Dynamics, Investment Dynamics, Non-linear Residual Income Dynamics
JEL Classification: M41, G12, G31
Suggested Citation: Suggested Citation