A Structural Accounting Framework for Estimating the Expected Rate of Return on Equity

35 Pages Posted: 20 Apr 2016

See all articles by Demetris Christodoulou

Demetris Christodoulou

University of Sydney Business School; Financial Research Network (FIRN)

Colin Clubb

University of London - King's College London - Department of Management

Stuart McLeay

University of Sussex; The University of Sydney

Date Written: March 2016

Abstract

This paper shows how the expected rate of return (ERR) on equity may be estimated using only published accounting results, based on the information dynamics of reported earnings. As accounting‐based valuation models conditional upon financial statement articulation lead to a rank deficient system of estimating equations, the paper introduces a nonlinear constraint on the articulation that allows the information system simultaneously to produce an estimate for the ERR by iteration, together with predictions for the key clean surplus forecasts of net earnings, net dividend, and the book value of equity. Further decomposition produces estimates of expected capital gain, expected earnings, and the expected change in equity book value, and by rearrangement, the expected change in unrecorded goodwill. The clean surplus relation is maintained in the forecast variables. Exploratory data methods are used to examine the nonlinear relationship between components of the accounting‐based ERR and realized stock returns. Findings show that realized returns are higher (lower) than estimated ERR in expansionary (recessionary) periods, with evidence of a stronger returns impact in recessionary periods. For the large majority of firms, realized returns revert to the estimated ERR, and the time‐varying accounting components are strongly related to future realized stock returns, consistent with time variation in the ERR around a long‐run average. Predicted earnings and dividends provide useful additional information on short‐run variations in the ERR.

Keywords: Clean surplus, Rank deficiency, Expected rate of return, Equity valuation

Suggested Citation

Christodoulou, Demetris and Clubb, Colin and McLeay, Stuart, A Structural Accounting Framework for Estimating the Expected Rate of Return on Equity (March 2016). Abacus, Vol. 52, Issue 1, pp. 176-210, 2016, Available at SSRN: https://ssrn.com/abstract=2767222 or http://dx.doi.org/10.1111/abac.12073

Demetris Christodoulou (Contact Author)

University of Sydney Business School ( email )

Instute of Transport and Logistics Studies (C37)
The University of Sydney
Sydney, NSW 2133
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

Colin Clubb

University of London - King's College London - Department of Management ( email )

150 Stamford Street
London, SE1 9NN
United Kingdom

Stuart McLeay

University of Sussex ( email )

Falmer, Brighton BN1 9SL
United Kingdom

The University of Sydney ( email )

Cnr. of Codrington and Rose Streets
Sydney, NSW 2006
Australia

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