Abstract
Continuing from the theoretical development in the previous chapter, in this chapter we examine the ROM more closely in order to better understand the valuation role of accounting variables (earnings, equity book value, and ROE). We then empirically test the model’s predictions. According to the ROM, capital investment activities play a crucial role in determining the relation between equity value and accounting data, and as shown in Chap. 4 and elaborated further below, there are two separate forces at work in this respect. Firstly, anticipated future investments (divestments) matter to the value-accounting relation because they determine the course of the firm’s operations going forward and expected future value generation. Secondly, past investments also matter because under conservative accounting practice, economic activities are measured in a biased fashion, with the direction and extent of such biases dependent on the trend of past investments. As before, we refer to the former as an economic force (propelled by incentives to pursue value), and the latter as an accounting force (arising from conservatism). The objective of this chapter is to explore and test the impact of these forces on the relation between equity value and accounting variables.
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Notes
- 1.
A normalized growth parameter (\( g \)) facilitates cross-sectional comparisons. Note that parameter \( G \) in original ROM (4.11) represents the amount of growth.
- 2.
Hao et al. (2011a) adopt an alternative method of control whereby they scale the regression variables by the control variable. The results are qualitatively the same using this scaling approach.
- 3.
The Bonferroni adjustment is needed to test a hypothesis involving two or more separate parts. To accept the whole hypothesis (in alternative form) at significance level α, the significance level for each individual part must be increased. Because the precise critical t-value that is applicable to all situations is not available, the adjustment relies on an inequality \( \Pr ({A_1}\cup {A_2})\leq \Pr ({A_1})+\Pr ({A_2}) \). Thus, if the significance level for both \( {A_1} \) and \( {A_2} \) is set to α/2, the significance level for accepting the whole hypothesis (which comprises \( {A_1} \) and \( {A_2} \)) is at least α.
- 4.
When ROE is close to zero, C(ROE) ≈ 0. Given that C(.) is increasing and convex in ROE, for ROE > 0, we have ROE C’(ROE) > C(ROE).
- 5.
In the real world, firms with low profitability may still grow for two reasons. Firstly, low current profitability may not be indicative of low profitability in future, which can hamper the usefulness of accounting information for forecasting and valuation. Secondly, firms with low profitability may have no good investment opportunities, but their managers may make investments to gain personal benefits (at the expense of investors). Both scenarios are beyond the scope of the theoretical model discussed here (that is, the ROM).
- 6.
This particular feature stems from the implicit assumption of constant returns to scale in the original model. However, this assumption is nonessential for the model’s properties being tested here.
Reference
Hao, S., Jin, Q., & Zhang, G. (2011a). Investment growth and the relation between equity value, earnings, and equity book value. The Accounting Review, 86(2), 605–635.
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Appendix A: The Empirical Sample and Variable Measurement
Appendix A: The Empirical Sample and Variable Measurement
The sample and variable measurement are as adopted by Hao et al. (2011a). The data are extracted from the Compustat database, and the variables are measured as follows: V (market value per share) is the market price of common shares at the fiscal year end; B (book value per share) is the book value of equity divided by the number of common shares outstanding, both at the fiscal year end; X (earnings per share) is diluted earnings per share excluding extraordinary items; and ROE (profitability) is earnings before extraordinary items divided by the book value of equity at the beginning of the fiscal year. We measure growth (g) using the average realized annual growth rate of equity book value over the subsequent 3 years. The sample excludes (i) regulated and financial industries and (ii) firms with a current- or prior-year total equity book value of less than $1 million. All continuous variables are winsorized at the top and bottom 1 % of the distributions. These steps result in a sample of 101,672 observations for the period 1966–2003.
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Zhang, G. (2014). Testing the Properties of the ROM. In: Accounting Information and Equity Valuation. Springer Series in Accounting Scholarship, vol 6. Springer, New York, NY. https://doi.org/10.1007/978-1-4614-8160-7_5
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DOI: https://doi.org/10.1007/978-1-4614-8160-7_5
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