Residual Income Valuation Models and Inflation

39 Pages Posted: 29 May 2007 Last revised: 5 May 2010

See all articles by David J. Ashton

David J. Ashton

University of Bristol - Department of Economics

Ken V. Peasnell

Lancaster University - Department of Accounting and Finance

Pengguo Wang

Xfi, University of Exeter

Date Written: May 5, 2010

Abstract

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

Ashton, David John and Peasnell, Kenneth V. and Wang, Pengguo, Residual Income Valuation Models and Inflation (May 5, 2010). European Accounting Review Forthcoming, Available at SSRN: https://ssrn.com/abstract=988689

David John Ashton

University of Bristol - Department of Economics ( email )

8 Woodland Road
Bristol BS8 ITN
United Kingdom
+44 (0)117 928 8423 (Phone)

Kenneth V. Peasnell

Lancaster University - Department of Accounting and Finance ( email )

The Management School
Lancaster LA1 4YX
United Kingdom
+44 1524 593631 (Phone)
+44 1524 847321 (Fax)

Pengguo Wang (Contact Author)

Xfi, University of Exeter ( email )

Streatham Court
Exeter, EX4 4PU
United Kingdom

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