The Roles of Earnings and Book Value in Equity Valuation: A Real Options Based Analysis

45 Pages Posted: 30 May 2002

See all articles by Peter F. Chen

Peter F. Chen

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

Guochang Zhang

University of Hong Kong

Date Written: May 2002

Abstract

Employing a real options based valuation model, this paper examines the valuation roles of earnings and book value and cross-sectional differences in valuation properties. Consistent with theoretical predictions, we find that (i) as profitability increases, the value impact of earnings increases whereas that of book value decreases and eventually becomes negative; (ii) the explanatory power of earnings increases, and that of book value decreases, monotonically with profitability, with the two accounting measures behaving as valuation substitutes within a certain intermediate-profitability range; (iii) the P/B ratio increases with both profitability and growth opportunity, whereas P/E behaves in a non-monotonic fashion. Implications are discussed for value-relevance research.

Keywords: equity valuation, earnings, book value, real options, profitability, growth opportunity

JEL Classification: M41, G12, G31

Suggested Citation

Chen, Peter Fusheng and Zhang, Guochang, The Roles of Earnings and Book Value in Equity Valuation: A Real Options Based Analysis (May 2002). Available at SSRN: https://ssrn.com/abstract=311800 or http://dx.doi.org/10.2139/ssrn.311800

Peter Fusheng Chen

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

Clear Water Bay
School of Business & Management
Kowloon
Hong Kong PRC
852-2358-7572 (Phone)

Guochang Zhang (Contact Author)

University of Hong Kong ( email )

KK Leung Building
Faculty of Business and Economics
Hong Kong
+852 3917 1076 (Phone)

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