What Determines Residual Income?

Posted: 2 Jul 2004 Last revised: 5 Mar 2014

See all articles by Qiang Cheng

Qiang Cheng

Singapore Management University

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This paper investigates the determinants of residual income scaled by book value of equity, i.e., abnormal return on equity (ROE), by analyzing the impact of value-creation (economic rents) and value-recording (conservative accounting) processes on abnormal ROE. I rely on economic theories to characterize economic rents and develop an empirical measure - the conservative accounting factor - to capture the effect of conservative accounting. As expected, industry abnormal ROE increases with industry concentration, industry level barriers to entry, and industry conservative accounting factors. Also as expected, the difference between firm and industry abnormal ROE increases with market share, firm size, firm level barriers to entry, and firm conservative accounting factors. Integrating these determinants into the residual income valuation model significantly increases its explanatory power for the variation in the market-to-book ratio.

Keywords: equity valuation, the residual income valuation model, economic rents, conservative accounting

JEL Classification: D40, G12, M41, M44

Suggested Citation

Cheng, Qiang, What Determines Residual Income?. Accounting Review 80 (1): 85-112, January 2005, Available at SSRN: https://ssrn.com/abstract=560801

Qiang Cheng (Contact Author)

Singapore Management University ( email )

60 Stamford Road
Singapore, 178900

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