On the relevance of earnings components in valuation
Published online: 16 February 2013
Ó Springer Science+Business Media New York 2013
Abstract This paper articulates the links between relevance of an earnings component in
forecasting (abnormal) earnings and its relevance in valuation in a nonlinear framework.
The analysis shows that forecasting relevance does not imply valuation relevance even
though valuation irrelevance is implied by forecasting irrelevance. Firstly, I consider an
accounting information system where earnings components ‘‘add up’’ to a fully informative
earnings number. Secondly, I analyze two accounting systems where a ‘‘core’’ earnings
component is the relevant earnings construct for valuation and the second earnings com-
ponent is irrelevant but may be predictable and relevant in forecasting other accounting
items. I ﬁnd that dividend displacement effect on earnings and the dynamics of individual
earnings components are critical in this analysis.
Keywords Valuation Á Forecasting Á Earnings components Á
Residual income valuation model
JEL Classiﬁcation G17 Á G32 Á M41
Financial analysts and empirical ﬁnancial accounting researchers often focus on the val-
uation relevance and forecasting ability of earnings components. Perhaps surprisingly,
theoretical equity valuation models provide only limited guidance on the appropriate
speciﬁcation of tests of informational relevance of earnings components. A valuation
irrelevant accounting variable can be forecasting relevant to the expected future earnings.
Dividends are examples of such a variable in the Miller and Modigliani (1961) framework.
Dividends paid affect future earnings expectations through the dividend displacement
effect - dividends reduce book equity from which future earnings are generated. However,
P. Wang (&)
Xﬁ Centre for Finance and Investment, Exeter University Business School, Exeter EX4 4ST, UK
Rev Quant Finan Acc (2014) 42:399–413