When Capital Follows Profitability: Non-linear Residual Income Dynamics

When Capital Follows Profitability: Non-linear Residual Income Dynamics Economic reasoning suggests that capital follows profitability. This study introduces into residual income valuation “capital follows profitability” investment dynamics whereby capital investments are guided by the profitability of underlying investment opportunities. These investment dynamics predict convex versus linear relations between future and current residual income, with slope and convexity dependent on investment opportunity. We test these predictions against the linear information dynamics (LID) proposed by Ohlson (1995) and Feltham and Ohlson (1996), with supportive results. These findings point the way to further development of links between firm value and the economics of value creation. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Accounting Studies Springer Journals

When Capital Follows Profitability: Non-linear Residual Income Dynamics

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Publisher
Kluwer Academic Publishers
Copyright
Copyright © 2001 by Kluwer Academic Publishers
Subject
Business and Management; Accounting/Auditing; Corporate Finance; Public Finance
ISSN
1380-6653
eISSN
1573-7136
D.O.I.
10.1023/A:1011666926073
Publisher site
See Article on Publisher Site

Abstract

Economic reasoning suggests that capital follows profitability. This study introduces into residual income valuation “capital follows profitability” investment dynamics whereby capital investments are guided by the profitability of underlying investment opportunities. These investment dynamics predict convex versus linear relations between future and current residual income, with slope and convexity dependent on investment opportunity. We test these predictions against the linear information dynamics (LID) proposed by Ohlson (1995) and Feltham and Ohlson (1996), with supportive results. These findings point the way to further development of links between firm value and the economics of value creation.

Journal

Review of Accounting StudiesSpringer Journals

Published: Oct 3, 2004

References

  • Comments on An Empirical Assessment of the Residual Income Valuation Model
    Beaver, W.
  • Measurement Error and Nonlinearity in the Earnings-Return Relation
    Beneish, M.; Harvey, C.
  • Investor Valuation of the Abandonments Option
    Berger, P.; Ofek, E.; Swary, I.
  • Evidence on EVA®
    Biddle, G.; Bowen, R.; Wallace, J.

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