Earnings, Adaptation, and Equity Value
Posted: 30 Apr 1998
Date Written: February 1996
This paper develops a model in which earnings and book value are complementary factors in determining equity value. Current earnings relative to book value provides information about how well the firm is currently using its resources. When current earnings to book value is high, the firm is likely to continue its current way of employing resources and earnings is the more important determinant of equity value. When current earnings to book value is low, the firm is more likely to adapt its resources to a superior alternative use, and book value becomes the more important determinant of equity value because book value provides a measure of the value of the firm's resources, independent of how well the resources are currently utilized. The model leads to two main empirical predictions: First, equity value is a convex function of expected earnings and book value. Second, the change in equity value associated with changes in expected earnings increases with the relative level of earnings to book value. Evidence from a variety of specifications is consistent with predictions. Thus, the results imply that equity value is a function of both expected earnings and book value (in contrast to models which incorporate one or the other) and that the form of the function is convex (in contrast to models which assume the two elements of value are simply additive).
JEL Classification: M41, G12
Suggested Citation: Suggested Citation