Abstract
The RIM introduced in Chap. 1 focuses on the valuation role of the expected residual income from future operations. Like other discount models such as the DDM and FCFM, the RIM is silent on how expectations of a firm’s future operations are formed. To understand the direct impact of financial reporting on capital markets where investors set firm values, we need a forecasting model that connects future residual income to what investors observe today, particularly reported accounting data.
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Notes
- 1.
At this point in our discussion, we omit “other” (that is, nonaccounting) information included in Ohlson’s (1995) LID. Later, we will examine the role of such information as modeled in various studies.
- 2.
See Cheng (2005) for a discussion of the economic and accounting factors explaining a firm’s residual income.
- 3.
Imagine an alternative scenario where a firm’s strengths or weaknesses in each period are expected to vanish instantaneously, and so performance over each period becomes purely random with no serial correlation. Here, financial data pertaining to the current operational period will be of no use for forecasting future performance.
- 4.
For example, observations drawn from \( {{\tilde{y}}_t}=x_t^2+{{\tilde{e}}_t} \) will yield a positive correlation between \( {x_t} \) and \( {y_t} \) in a domain of positive \( {x_t} \)-values. Myers (1999) argues that nonlinear dynamics are not internally consistent, but his argument is derived from a special case of nonlinearity (piecewise linear specifications) and does not apply in general.
- 5.
There are other branches of valuation research, such as (i) using expected future earnings and earnings growth to determine equity value (see, for example, Frankel and Lee 1998 and Liu and Thomas 2000), which emphasize the role of expected future earnings rather than realized earnings, and (ii) relying on the RIM to infer the implied cost of capital. Both are outside the scope of our discussion.
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Zhang, G. (2014). Mapping Accounting Data to Value via Linear Information Dynamics: The Early Approach. 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_2
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