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Earnings Components, Accounting Bias and Equity Valuation

Author

Listed:
  • Peter F. Pope

    (Lancaster University Management School)

  • Pengguo Wang

    (Tanaka Business School, Imperial College)

Abstract

In this paper we address three issues in accounting-based equity valuation: (i) How are valuation parameters related to earnings persistence and accounting conservatism when earnings components aggregate, or “add up”, in valuation? (ii) What does aggregation of earnings components in valuation imply for abnormal earnings dynamics? and (iii) When is an earnings component “irrelevant” and “core”␣earnings the relevant construct for valuation? Assuming linear valuation, no-arbitrage, dividend irrelevance and clean surplus accounting, we show that when earnings components aggregate, valuation expressions and abnormal earnings dynamics are generalizations of the Ohlson (1995) model, incorporating simple adjustments for accounting conservatism. When “core” earnings are the relevant earnings construct, valuation expressions closely resemble the aggregation case, but core (abnormal) earnings replaces clean surplus (abnormal) earnings. We demonstrate that an earnings component can be irrelevant in valuation even when it is predictable.

Suggested Citation

  • Peter F. Pope & Pengguo Wang, 2005. "Earnings Components, Accounting Bias and Equity Valuation," Review of Accounting Studies, Springer, vol. 10(4), pages 387-407, December.
    • Handle: RePEc:spr:reaccs:v:10:y:2005:i:4:d:10.1007_s11142-005-4207-4
    DOI: 10.1007/s11142-005-4207-4
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    JEL classification:

    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting
    • M49 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Other
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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