Implied Cost of Equity Capital in Earnings-Based Valuation: International Evidence

Accounting and Business Research, Vol. 34, No. 4, pp. 323-344, 2004

43 Pages Posted: 19 Jul 2004 Last revised: 7 Dec 2009

See all articles by Feng Chen

Feng Chen

University of Toronto - Rotman School of Management

Bjorn Jorgensen

London School of Economics & Political Science (LSE) - Department of Accounting and Finance

Yong Keun Yoo

Korea University Business School

Abstract

Assuming the clean surplus relation, the Edwards-Bell-Ohlson residual income valuation (RIV) model expresses market value of equity as the sum of the book value of equity and the expected discounted future residual incomes. Without assuming the clean surplus relation, Ohlson and Juettner-Nauroth (2000) articulate the role of forward earnings per share in valuation. We compare the implied costs of equity capital from these two approaches to earnings-based valuation within seven developed countries. We hypothesize superior performance from the RIV model in countries where the clean surplus relation holds well. First, we provide preliminary international evidence on the frequency and magnitude of the clean surplus deviations. Consistent with our hypothesis, we document superior reliability of the implied cost of equity capital derived from the RIV model when clean surplus adequately describes the firms' financial reporting. That is, the implied cost of equity capital derived from Ohlson and Juettner-Nauroth (2000) is relatively more reliable in countries where the clean surplus deviations are common. Our analyses suggest that the proper choice of earnings-based valuation model may depend on analysts' interpretation of their financial reporting environment.

Keywords: Accounting-based valuation, Clean surplus, Cost of capital, International

JEL Classification: G12, G15, G29, M41, M47

Suggested Citation

Chen, Feng and Jorgensen, Bjorn N and Yoo, Yong Keun, Implied Cost of Equity Capital in Earnings-Based Valuation: International Evidence. Accounting and Business Research, Vol. 34, No. 4, pp. 323-344, 2004. Available at SSRN: https://ssrn.com/abstract=565784

Feng Chen

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Bjorn N Jorgensen (Contact Author)

London School of Economics & Political Science (LSE) - Department of Accounting and Finance ( email )

Department of Accounting Room, OLD 2.17
Houghton Street
London, WC2A 2AE
United Kingdom

HOME PAGE: http://www.lse.ac.uk/accounting/people/bjorn-jorgensen

Yong Keun Yoo

Korea University Business School ( email )

1 Anam-dong 5 ka
Seoul, 136-701
Korea, Republic of (South Korea)

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