Residual Income Valuation Models and Inflation
39 Pages Posted: 29 May 2007 Last revised: 5 May 2010
Date Written: May 5, 2010
Existing empirical evidence suggests that residual income valuation models based on historical cost accounting considerably underestimate equity values. One possible explanation is the use of historical cost accounting under inflationary conditions. In this paper, we use a residual income framework to explore theoretically how historical cost accounting numbers need to be adjusted for inflation in forecasting and valuation.
We demonstrate that even in a simple setting where inflation is running at a relatively low level, residual income models are likely to produce severe under-valuations if inflation is not properly taken into account. We use simulated data to reinforce our theoretical findings and to illustrate the difficulties that empirical investigators face working within the confines imposed by real data.
Keywords: Residual Income Models, Inflation, Equity Valuation models
JEL Classification: G12, M41, E31
Suggested Citation: Suggested Citation