Profitability, Earnings and Book Value in Equity Valuation: A Geometric View and Empirical Evidence

Hong Kong University of Science and Technology Working Paper

61 Pages Posted: 30 Sep 2003

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: August 2003

Abstract

This paper develops the geometric representation of an equity valuation model to illustrate how equity value relates simultaneously to profitability, earnings, and equity book value, and empirically tests those relations. We depict Zhang's (2000) model as a "surface" in the three-dimensional space, defined by profitability (ROE), book value, and equity value, to provide a "full view" of the valuation mapping. The geometry offers a convenient way to show visually how balance sheet and income statement measures are integrated and how equity value behaves in relation to different accounting measures.

We predict that equity value is an increasing and convex function of profitability (and earnings) given book value, a linear function of book value given profitability, and a non-monotonic and convex function of book value given earnings. We further show that these predicted effects are more pronounced for firms with greater growth opportunities. Empirical results are consistent with our predictions. The study provides a framework to unify empirical findings (including those from prior studies). It presents a more complete and integrated picture of how accounting data are mapped into value.

Keywords: geometry of equity valuation, equity value, profitability, book value, earnings, growth opportunity

JEL Classification: M41, G12, G31

Suggested Citation

Chen, Peter Fusheng and Zhang, Guochang, Profitability, Earnings and Book Value in Equity Valuation: A Geometric View and Empirical Evidence (August 2003). Hong Kong University of Science and Technology Working Paper. Available at SSRN: https://ssrn.com/abstract=442260 or http://dx.doi.org/10.2139/ssrn.442260

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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