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

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