Skip to main content
SpringerLink
Log in

When Capital Follows Profitability: Non-linear Residual Income Dynamics

  • Published:
Review of Accounting Studies Aims and scope Submit manuscript

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.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Similar content being viewed by others

References

  • Anthony, R. (1973). “Accounting for the Cost of Equity.” Harvard Business Review 51, 88-102.

    Google Scholar 

  • Ball, R. and R. Watts. (1972). “Some Time Series Properties of Accounting Income. ”Journal of Finance (June), 663-681.

  • Barth, W.,W. Beaver and W. Landsman. (1998). “Relative Valuation Roles of Equity Book Value and Net Income as a Function of Financial Health.” Journal of Accounting and Economics 25 (February), 1-34.

  • Beaver, W. (1970). “The Time Series Behavior of Earnings.” Journal of Accounting Research (Supplement 8), 62-89.

    Google Scholar 

  • Beaver, W. (1999). “Comments on An Empirical Assessment of the Residual Income Valuation Model.” Journal of Accounting and Economics 26, 35-42.

    Google Scholar 

  • Beneish, M. and C. Harvey. (1998). “Measurement Error and Nonlinearity in the Earnings-Return Relation.” Review of Quantitative Finance and Accounting 11, 219-247.

    Google Scholar 

  • Berger, P., E. Ofek and I. Swary. (1996). “Investor Valuation of the Abandonments Option.” Journal of Financial Economics 42 (October), 257-287.

    Google Scholar 

  • Biddle, G., R. Bowen and J. Wallace. (1997). “Does EVA Beat Earnings? Evidence on Associations with Stock Returns and Firm Values.” Journal of Accounting and Economics 24, 301-336.

    Google Scholar 

  • Biddle, G., R. Bowen and J. Wallace. (1999). “Evidence on EVA®.” Journal of Applied Corporate Finance 12, 8-18.

    Google Scholar 

  • Biddle, G., R. Bowen, and J. Wallace. (2000). “EVA® and Financial Analysis.” Working paper, Hong Kong University of Science and Technology.

  • Brooks, L. and D. Buckmaster. (1976). “Further Evidence on the Time Series Properties of Accounting Income.” Journal of Finance 31, 1359-1373.

    Google Scholar 

  • Burgstahler, D. and I. Dichev. (1997). “Earnings, Adaptation, and Equity Value.” The Accounting Review 73, 187-215.

    Google Scholar 

  • Canning, J. (1929). The Economics of Accountancy. New York: Ronald Press.

    Google Scholar 

  • Chen, P. and G. Zhang. (2000). “Heterogeneous Investment Opportunities in Multiple-Segment Firms and the Incremental Value Relevance of Segment Accounting Data.” Working Paper, Hong Kong University of Science and Technology.

  • Collins, D., E. Maydew and I. Weiss. (1997). “Changes in the Value-Relevance of Earnings and Book Values over the Past Forty Years.” Journal of Accounting and Economics 24, 39-67.

    Google Scholar 

  • Collins, D., M. Pincus and H. Xie. (1999). “Equity Valuation and Negative Earnings: the Role of Book Value of Equity. The Accounting Review 74, 29-61.

    Google Scholar 

  • Das, S. and B. Lev. (1994). “Nonlinearity in the Return-Earnings Relation: Tests of Alternative Specifications and Explanations.” Contemporary Accounting Research 11, 353-379.

    Google Scholar 

  • Dechow, P., A. Hutton and R. Sloan. (1999). “An Empirical Assessment of the Residual Income Valuation Model.” Journal of Accounting and Economics 26, 1-34.

    Google Scholar 

  • Easton, P. (1999). “Security Returns and the Value Relevance of Accounting Data.” Accounting Horizons 13 (December), 399-412.

    Google Scholar 

  • Easton, P. and T. Harris. (1991). “Earnings as an ExplanatoryVariable for Returns.” Journal of Accounting Research 29, 19-36.

    Google Scholar 

  • Edey, H. (1957). “Business Valuation, Goodwill and the Super-Profit Method.” Accountancy, January/February.

  • Edwards, E. and P. Bell. (1961). The Theory and Measurement of Business Income. Berkeley: University of California Press.

    Google Scholar 

  • Fama, E. and K. French. (2000). “Forecasting Profitability and Earnings.” Journal of Business 73, 161-175.

    Google Scholar 

  • Feltham, G. and J. Ohlson. (1995). “Valuation and Clean Surplus Accounting for Operating and Financial Activities.” Contemporary Accounting Research 11, 689-731.

    Google Scholar 

  • Feltham, G. and J. Ohlson. (1996). “Uncertainty Resolution and the Theory of Depreciation Measurement”. Journal of Accounting Research 34, 209-234.

    Google Scholar 

  • Feltham, G. and J. Ohlson. (1999). “Residual Income Valuation with Risk and Stochastic Interest Rates.” The Accounting Review 74, 165-183.

    Google Scholar 

  • Freeman, R., J. Ohlson, and S. Penman. (1982). “Book Rate-of-Return and Prediction of Earnings Changes: An Empirical Investigation.” Journal of Accounting Research 20, 639-653.

    Google Scholar 

  • Freeman, R. and S. Tse. (1992). “A Nonlinear Model of Security Price Response to Accounting Earnings.” Journal of Accounting Research 30, 185-209.

    Google Scholar 

  • Hamilton, R. (1777). An Introduction to Merchandize. Edinburgh.

  • Hand, J. and W. Landsman. (1999). “The Pricing of Dividends in Equity Valuation.” Working Paper, University of North Carolina at Chapel Hill.

  • Hayne, C. (1999). “The Information Content of Losses.” Journal of Accounting and Economics 20 (September), 125-153.

    Google Scholar 

  • Kay, J. (1976). “Accountants, Too, Could be Happy in a Golden Age: The Accountant's Rate of Profit and the Internal Rate of Return.” Oxford Economic Papers 28, 447-460.

    Google Scholar 

  • Lee, C. (1999). “Accounting-Based Valuation: Impact on Business Practices and Research.” Accounting Horizons 13, 413-426.

    Google Scholar 

  • Lo, K. and T. Lys. (1999). “The Ohlson Model: Contribution to Valuation Theory, Limitations, and Empirical Applications.” Working Paper, University of British Columbia. (Forthcoming, Journal of Accounting, Auditing and Finance).

  • Marshall, A. (1890). Principles of Economics. New York: MacMillan Press.

    Google Scholar 

  • Miller, M. and F. Modigliani. (1961), “Dividend Policy, Growth and the Valuation of Shares,” Journal of Business 34, 411-433.

    Google Scholar 

  • Myers, J. (1999). “Implementing Residual Income Valuation with Linear Information Dynamics. The Accounting Review 74, 1-23.

    Google Scholar 

  • Nissim, D. and S. Penman. (1999). “Ratio Analysis and Equity Valuation.” Working Paper, Columbia University.

  • Ohlson, J. (1995). “Earnings, BookValue, and Dividends in EquityValuation.” Contemporary Accounting Research 11, 661-687.

    Google Scholar 

  • Ohlson, J. (2000). “Positive (Zero) NPV Projects and the Behavior of Residual Earnings.” Working Paper, New York University.

  • Peasnell, K. (1981). “On Capital Budgeting and Income Measurement.” Abacus 17, 52-67.

    Google Scholar 

  • Peasnell, K. (1982). “Some Formal Connections between Economic Values and Yields and Accounting Numbers.” Journal of Business, Finance and Accounting 9, 361-381.

    Google Scholar 

  • Penman, S. (1997). “A Synthesis of Equity Valuation Techniques and the Terminal Value Calculation for the Dividend Discount Model.” Review of Accounting Studies 2, 303-323.

    Google Scholar 

  • Penman, S. (2001). Financial Statement Analysis and Security Valuation.NewYork: McGraw-Hill Book Company.

    Google Scholar 

  • Preinreich, G. (1938). “Annual Survey of Economic Theory: The Theory of Depreciation.” Econometrica 6, 219-241.

    Google Scholar 

  • Solomons, D. (1965). Division Performance: Measurement and Control. NewYork: Financial Executives Research Foundation.

    Google Scholar 

  • Stewart, G. Bennett III. (1991). The Quest For Value. New York: Harper Business.

    Google Scholar 

  • Subramanyam, K. R. (1996). “Uncertain Precision and Price Reactions to Information.” The Accounting Review 71, 207-220.

    Google Scholar 

  • Subramanyam, K. R. and J. Wild. (1993). “The Going Concern Assumption and the Informativeness of Earnings.” Contemporary Accounting Research 13 (Spring), 251-273.

    Google Scholar 

  • Verrecchia, R. (1998). “Discussion of Accrual Accounting and EquityValuation.”Journal of Accounting Research, Supplement 36, 113-115.

    Google Scholar 

  • Watts, R. and R. Leftwich. (1977). “The Time-Series Properties of Annual Accounting Earnings.” Journal of Accounting Research 15, 253-279.

    Google Scholar 

  • Yee, K. (2000). “Opportunities Knocking: Residual Income Valuation of the Adaptive Firm.” (Forthcoming, Journal of Accounting, Auditing, and Finance).

  • Zhang, G. (2000).“Accounting Information, Capital Investment Decisions, and Equity Valuation: Theory and Empirical Implications.” Journal of Accounting Research 38 (Autumn), 271-295.

    Google Scholar 

  • Zhang, X.-J. (2000). “Conservative Accounting and Equity Valuation.” Journal of Accounting and Economics 29 (February), 125-149.

    Google Scholar 

Download references

Author information

Authors and Affiliations

  1. Department of Accounting, Hong Kong University of Science & Technology, Clear Water Bay, Kowloon, Hong Kong

    Gary C. Biddle, Peter Chen & Guochang Zhang

Authors
  1. Gary C. Biddle
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Peter Chen
    View author publications

    You can also search for this author in PubMed Google Scholar

  3. Guochang Zhang
    View author publications

    You can also search for this author in PubMed Google Scholar

Rights and permissions

Reprints and permissions

About this article

Cite this article

Biddle, G.C., Chen, P. & Zhang, G. When Capital Follows Profitability: Non-linear Residual Income Dynamics. Review of Accounting Studies 6, 229–265 (2001). https://doi.org/10.1023/A:1011666926073

Download citation

  • Issue Date:

  • DOI: https://doi.org/10.1023/A:1011666926073

Search

Navigation