A State Space Framework for the Residual Income Valuation Model of Stock Prices

69 Pages Posted: 18 Oct 2019 Last revised: 3 Dec 2020

See all articles by Faisal M. Awwal

Faisal M. Awwal

Southeast Toyota Finance (SETF) - Data & Analytics

Prasad V. Bidarkota

Florida International University (FIU) - Department of Economics

Date Written: December 1, 2020

Abstract

We assess the empirical implications of the valuation model for equity prices developed in Ohlson (1995), by accounting for residual income information dynamics. A key assumption of the Ohlson (1995) residual income model stipulates that next period t + 1 residual income is a linear function of current period t residual income and a latent variable referred to as ‘other information’. This ‘other information’, assumed known in the current period t, contains information on next period t+1 abnormal earnings not reflected in current period t abnormal earnings. Previous literature has proxied this ‘other information’ variable with consensus analysts’ forecasts of earnings. In this study, we propose to estimate this latent ‘other information’ variable using a state space framework. Our method obviates the need for analysts’ earnings forecasts. We estimate the valuation model, within the embedded state space framework, using the Kalman filter recursive procedure. We estimate the model across a sample of stocks in the Dow Jones 30 and S&P 500 indices. We compare the model performance to a benchmark two-step regression approach used in previous work. Performance yardsticks indicate that our state space estimation approach shows promise in valuing stocks and predicting next period t+1 residual income relative to the benchmark approach.

Keywords: Residual Income Valuation Model, Stock Prices, State Space Modelling, Kalman Filtering, Present-Value Model, Equity Forecasting

JEL Classification: C32, G10, G12

Suggested Citation

Awwal, Faisal M. and Bidarkota, Prasad V., A State Space Framework for the Residual Income Valuation Model of Stock Prices (December 1, 2020). Available at SSRN: https://ssrn.com/abstract=3466181 or http://dx.doi.org/10.2139/ssrn.3466181

Faisal M. Awwal (Contact Author)

Southeast Toyota Finance (SETF) - Data & Analytics ( email )

100 Jim Moran Blvd
Deerfield Beach, FL 33442
United States

Prasad V. Bidarkota

Florida International University (FIU) - Department of Economics ( email )

University Park, DM 320A
Florida International University
Miami, FL 33199
United States
305-348-6362 (Phone)
305-348-1524 (Fax)

HOME PAGE: http://www.fiu.edu/~bidarkot/

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