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When Capital Follows Profitability: Non-linear Residual Income Dynamics

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  • Gary C. Biddle

    (Hong Kong University of Science & Technology)

  • Peter Chen

    (Hong Kong University of Science & Technology)

  • Guochang Zhang

    (Hong Kong University of Science & Technology)

Abstract

Economic reasoning suggests that capital follows profitability. This study introduces into residual income valuation “capital follows profitability” investment dynamics whereby capital investments are guided by the profitability of underlying investment opportunities. These investment dynamics predict convex versus linear relations between future and current residual income, with slope and convexity dependent on investment opportunity. We test these predictions against the linear information dynamics (LID) proposed by Ohlson (1995) and Feltham and Ohlson (1996), with supportive results. These findings point the way to further development of links between firm value and the economics of value creation.

Suggested Citation

  • Gary C. Biddle & Peter Chen & Guochang Zhang, 2001. "When Capital Follows Profitability: Non-linear Residual Income Dynamics," Review of Accounting Studies, Springer, vol. 6(2), pages 229-265, June.
    • Handle: RePEc:spr:reaccs:v:6:y:2001:i:2:d:10.1023_a:1011666926073
    DOI: 10.1023/A:1011666926073
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    References listed on IDEAS

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    6. Dechow, Patricia M. & Hutton, Amy P. & Sloan, Richard G., 1999. "An empirical assessment of the residual income valuation model1," Journal of Accounting and Economics, Elsevier, vol. 26(1-3), pages 1-34, January.
    7. Zhang, Xiao-Jun, 2000. "Conservative accounting and equity valuation," Journal of Accounting and Economics, Elsevier, vol. 29(1), pages 125-149, February.
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    12. Beaver, William H., 1999. "Comments on 'An empirical assessment of the residual income valuation model'," Journal of Accounting and Economics, Elsevier, vol. 26(1-3), pages 35-42, January.
    13. Biddle, Gary C. & Bowen, Robert M. & Wallace, James S., 1997. "Does EVA(R) beat earnings? Evidence on associations with stock returns and firm values," Journal of Accounting and Economics, Elsevier, vol. 24(3), pages 301-336, December.
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    Cited by:

    1. Lee-Seok Hwang & Byungcherl Charlie Sohn, 2010. "Return predictability and shareholders’ real options," Review of Accounting Studies, Springer, vol. 15(2), pages 367-402, June.

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