Review of Accounting Studies, 6, 387–395, 2001
2001 Kluwer Academic Publishers. Manufactured in The Netherlands.
Book Value, Residual Earnings, and Equilibrium
Firm Value with Asymmetric Information
YOUNG K. KWON
Department of Accountancy, College of Commerce and Business Administration, University of Illinois at Urbana-
Champaign, 1206 South Sixth Street, Champaign, IL 61820
Abstract. The residual income valuation model (RIM) by Ohlson (1995) and Feltham and Ohlson (1995) assumes
that investors are risk-neutral with homogenous beliefs. Thus, the present value of expected dividends represents
ﬁrm value. The purpose of the present study is to derive a RIM in a market setting of the Kyle (1985) type.
Since traders are asymmetrically informed in the Kyle setting, ﬁrm value is no longer equivalent to the present
value of the ﬁrm’s expected dividends. In the present model, the informed investor observes a signal about the
ﬁrm’s proﬁtability, which the market maker (who sets the price) is unable to observe. The market maker infers
the informed investor’s private signal based on the total order ﬂow, which is an informative but noisy signal. The
analysis identiﬁes the equilibrium ﬁrm value as a linear function of current book value, current residual income,
and the aggregate order ﬂow.
Keywords: book value, residual earnings, equilibrium ﬁrm value, Kyle model, information asymmetry
In seminal articles, Ball and Brown (1968) and Beaver (1968) found evidence that security
price changes are associated with changes in accounting earnings. Since then, the relevance
of accounting data for ﬁrm valuation has been the focus of numerous empirical studies
(cf. Beaver, 1997). In this regard, the residual income valuation model (RIM) developed
by Ohlson (1995) and extended by Feltham and Ohlson (1995) provides an important
theoretical link between accounting data and ﬁrm value.
The purpose of this study is to
derive an accounting-based ﬁrm valuation model in an asymmetric information environment
of the Kyle (1985) type in which some market participants are more informed than others.
The RIM is based on three assumptions: (i) present value pricing; (ii) clean surplus
relation; and (iii) linear information dynamics. The present study also relies on assumptions
(ii) and (iii). However, given diverse investor information endowments, the present value of
expected dividends no longer represents ﬁrm value as (i) assumes. The analysis of this study
focuses on how investors’ differing information signals are aggregated to form equilibrium
ﬁrm value. Firm valuation is viewed here as a mapping from information sets to equilibrium
ﬁrm value. Since accounting data is an integral part of the information sets, the mapping links
accounting data to ﬁrm value. Such a model provides an important theoretical link between
accounting data and ﬁrm value for model constructions and interpretation of ﬁndings in
capital markets research.
The following section develops a capital market setting of the Kyle (1985) type. The main
result is derived in Section 2, and Section 3 concludes the paper with a brief summary. For
convenience, all proofs are included in the Appendix.