Abstract
In this chapter, we further develop the concept of capital following profitability in order to construct a model of equity value. As explained in Chap. 3, the essence of this notion is that firms do not commit themselves in advance to a fixed schedule of investment activities over time; instead, they adjust the course of their operations in such a way as to enable them to take advantage of investment opportunities arising in an evolving environment. This flexibility in investment decisions gives rise to real options, which are an important source of firm value.
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Notes
- 1.
Several other studies have explored, on a theoretical basis, the effect of adaptation (abandonment) options on the relation between equity value and accounting data (see for example Yee 2000; Ashton et al. 2003). That real options are an important part of firm value has long been noted in the finance literature (see for example Myers 1977; Brennan and Schwartz 1985; Berger et al. 1996; Dixit and Pindyck 1994).
- 2.
A positive link between current and future firm performance is the precondition to accounting-based valuation as a meaningful exercise at all. Without such a link, a firm’s performance in each period becomes purely random, which would render financial reporting of little or no use for forecasting and valuation purposes.
- 3.
For simplicity, we assume that operating assets are traded at a constant price over time. This assumption is relaxed later (in Chap. 11) where we examine the valuation role of fair value accounting.
- 4.
We assume that the firm is solely equity financed, but it is straightforward to extend the analysis to a financially leveraged firm.
- 5.
That ROE serves as a primitive construct in valuation accords with the view of the Financial Accounting Standards Board (FASB), which states in Statement of Financial Accounting Concepts (SFAC) No.5, paragraph 24a, that “statements of earnings and comprehensive income generally reflect a great deal about the profitability of an entity during a period, but that information can be interpreted most meaningfully … only if it is used in conjunction with a statement of financial position, for example, by computing rates of returns on assets or equity.”
- 6.
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Zhang, G. (2014). A Basic Model of Equity Value: Incorporating Growth and Abandonment Options. 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_4
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DOI: https://doi.org/10.1007/978-1-4614-8160-7_4
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