The effects of growth on the equity multiples: An international comparison

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Conservative accounting and zero net present value investments

Goodwill can reflect either the understatement of the value of existing assets or the anticipation of future positive NPV investments. In this case unbiased accounting results in capitalization of the initial investment in operating assets. Conservative accounting, in contrast, results in capitalization of only a fraction of that investment and expensing of the remainder. As a result, conservative accounting, on average, results in low earnings in the early periods and large earnings in the later period.

Growth and firm value for shareholders:

The two preceding models have been developed from the hypothesis about the dynamics of total earnings expressed in monetary units but it is normal to decompose earnings as a product of a volume capital invested and rate of return. In the previous models, the appraisal is done through capital invested BV. But nothing has been said about evolution of return on equity ROE.
The first model permitting the evolution of ROE. In fact, we can write:
Noting 1+ c = Bt , the estimated growth in the capital, we get:
It is clear that nothing is supposed in the previous model on dynamics of c. It may be varying. However, if c varies, it implies a negative variation and perfectly compensates the persistence of increase in ROE and the increase of the growth factor on cost of capital. Is it a reasonable hypothesis? This question can be answered only empirically.

Rent and Firm value for its shareholders:

One of the major critics on the previous modeling is in choosing an autoregressive model for residual income. One supposes that this residual income tends to 0 with time, meanwhile it is difficult to accept this idea that the company can generate investment opportunities at NPV zero. This supposes extremely strong condition of competition. We purpose the following modeling in terms of ROE.


In this section we summarize the findings of John O’Hanlon and Ken Peasnell (2004) which they presented in the article “Residua l Income Valuation: Are Inflation Adjustment Necessary? They argue that, in a setting in which accounting numbers and forecasts thereof are normally presented in historical cost terms, the inflation adjustment of RIV is likely to bring unnecessary complications to the valuation process, with increase scope for error. They present two formulations of RIV, each of which is based on inflation –adjusted income measure that has appeared in prior literature. The first formulation is based on current cost residual income. The second is based on real current cost residual income, being current cost residual income less a purchasing- power capital maintenance charge. They demonstrate that each is equivalent to the standard historical cost of RIV; consequently, neither is any more correct nor any less correct than that standard formulation of RIV.

Residual Income –Based Valuation Using Histori cal Cost Numbers:

RIV has three foundations that is present value relationship (which is the corner stone of theory of asset valuation), clean surplus relationship and Residual Income denoted by the following expressions: Where Pt is the intrinsic value of equity at time t, dt is the dividend net of new equity contribution at time t , Re , tk denotes the nominal cost of equity EBITDth , less applicable to the equity capital of time t+k-1, and Et . denotes expectations at time t. All transaction are assumed to occur at the end of the relevant period. Where BV denotes the book values of equity and X denotes the earnings. Residual Income assumption is given by:

Table of contents :

Table of contents
General Introduction
Chapter 1: Residual Income (R.I.V.) and Abnormal Earnings Growth (A.E.G)
1. Introduction
2. The Ohlson Model
2.1.1 The present value of expected dividends
2.1.2 Residual Income Valuation
2.1.3 Linear Information Model
2.1.4 Discounted cash flows (under risk neutrality) and Ohlson model
2.2 Feltahm- Ohlson (1995) Model
2.2.1 Relation between value and expectations about future accounting numbers Clean surplus accounting Net interest relation Pt equal PVED Unbiased versus conservative accounting for operating assets
2.2.2 Relation between value and current accounting numbers
2.2.3 Asymptotic relations among value, value changes and contemporaneous accounting numbers Price/earnings relation Relation between change in value and accounting earnings Relation between book value and accounting earnings
2.2.4 Comparative dynamics : cash earnings versus accrued earnings
2.2.5 Conservative accounting and zero net present value investment
2.3 Some particular cases
2.3.1 Growth and firm value for shareholders
2.3.2 Rent and firm value for shareholders
3. Modeling with probability of survival
Section 3
3 Inflation and inflation accounting 
3.1 Inflation Adjustment of RIV
3.2 Residual Income-based valuation using historical cost numbers
3.3 Residual Income using inflation adjusted numbers
3.4 RIV on a nominal current cost basis
3.5 RIV on a real current cost basis
3.6 Empirical inquiries on RIV from nominal, real and pure accounting angle
Section 4
4 Abnormal earnings growth 
4.1The OJ model: An overview
4.2Basics of the model
4.2.1 Adding structure to AEG
4.2.2 Properties of OJ formula
4.2.3 A special case of OJ model: the market to book model
4.2.4 Another special case of OJ model: Free cash flows and their growth
4.3The OJ model and dividend policy irrelevancy
4.4The labeling of Xt as expected earnings
4.4.1 The analytical properties of Xt
4.4.2 The OJ model derived from the four properties of earnings
4.5 Capitalized expected earnings as estimate of terminal value
4.6 The OJ model and cost of equity capital
4.7 Accounting rules and the OJ formula
4.8 Information Dynamics that sustain the OJ model
4.9 Operating versus financial activities
4.9.1 Proposition
4.9.2 Information dynamics for operating and financial activities
Chapter 2: The effects of growth on the equity multiples: An international comparison 
Section 1
1. Introduction 
Section 2
2. Problematic and model
2.1The source of the model
2.2The valuation model based on residual income and dirty surplus
Section 3
3. Data and descriptive statistics 
3.1Constitution of the samples
3.2Descriptive statistics
Section 4
4. Estimation of other explanatory variables 
4.1Measurement of the growth phase
4.2Measurement of the “dirty surplus”
4.3 Measurement of the income and variable representing other information
Section 5
5. Regression analysis: results 
5.1The role of book value of equity in association with market value
5.2The association between phases of development, level of indebtedness and stock market values.
5.3The contribution of information provided by the table of jobs and resources
5.4The contribution of the variables of forecast of net income
Chapter 3: What is the impact of abnormal earnings growth on the market valuation of companies? An international comparison. 
1. Introduction 
Section 2
2. Problematic and model 
2.1The source of model
2.2The valuation model from abnormal earning growth and growth opportunities
2.3The specification of the model tested
Section 3
3. Data and descriptive statistics 
3.1Constitution of the samples
3.2Descriptive statistics
Section 4
4. The empirical results 
4.1 Association between market values and expected earnings without taking into account dividends
4.2 Quality of forecasts and association of variables
4.3 Estimation of expected implied rate of return by country over the period
Section 5
5. Robustness tests 
5.1Implied rate of return and risk factors
5.2Implied return and precision of forecasts
5.3Measure of association and implied rate of return when expected variation of earnings is positive
5.4Direct estimates of the rates of persistence of abnormal earnings growth
General conclusion
Tables and figures

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