When Capital Follows Profitability: Non-Linear Residual Income Dynamics

75 Pages Posted: 27 Dec 2000

See all articles by Gary C. Biddle

Gary C. Biddle

University of Melbourne - Faculty of Business and Economics; Columbia University - Columbia Business School; London Business School; University of Melbourne; The University of Hong Kong

Peter F. Chen

Hong Kong University of Science & Technology (HKUST) - Department of Accounting

Guochang Zhang

University of Hong Kong

Date Written: 15 November 2000

Abstract

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

Biddle, Gary C. and Chen, Peter Fusheng and Zhang, Guochang, When Capital Follows Profitability: Non-Linear Residual Income Dynamics (15 November 2000). Review of Accounting Studies, June/September 2001. Available at SSRN: https://ssrn.com/abstract=251188 or http://dx.doi.org/10.2139/ssrn.251188

Gary C. Biddle (Contact Author)

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Guochang Zhang

University of Hong Kong ( email )

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