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Residual Income Valuation Models and Inflation

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  • David Ashton
  • Ken Peasnell
  • Pengguo Wang

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.

Suggested Citation

  • David Ashton & Ken Peasnell & Pengguo Wang, 2011. "Residual Income Valuation Models and Inflation," European Accounting Review, Taylor & Francis Journals, vol. 20(3), pages 459-483, May.
    • Handle: RePEc:taf:euract:v:20:y:2011:i:3:p:459-483
    DOI: 10.1080/09638180.2010.493661
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    Cited by:

    1. Alibey Kudar & Güven Sayılgan, 2021. "A new sustainable dividend policy and valuation model: Decreasing growth rate model," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 42(6), pages 1638-1642, September.
    2. Budi Frensidy & Ryan Joshua Pelealu & Robiyanto Robiyanto, 2020. "Analysis of Equity Valuation Models and Target Price Accuracy: An Evidence From Analyst Reports in Indonesia," SAGE Open, , vol. 10(4), pages 21582440209, October.
    3. Johansson, Sven-Erik & Hjelström, Tomas & Hellman, Niclas, 2016. "Accounting for goodwill under IFRS: A critical analysis," Journal of International Accounting, Auditing and Taxation, Elsevier, vol. 27(C), pages 13-25.
    4. Eddie Chamisa & Musa Mangena & Hamutyinei Harvey Pamburai & Venancio Tauringana, 2018. "Financial reporting in hyperinflationary economies and the value relevance of accounting amounts: hard evidence from Zimbabwe," Review of Accounting Studies, Springer, vol. 23(4), pages 1241-1273, December.
    5. Iris Bergmann & Wolfgang Schultze, 2018. "Accounting based valuation: a simultaneous equations model for forecasting earnings to proxy for ‘other information’," Review of Quantitative Finance and Accounting, Springer, vol. 50(4), pages 1057-1091, May.

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