Summary
We incorporate a real option component into the Ohlson (1995) equity valuation model and then use this augmented model to make assessments about the form and nature of the systematic biases that are likely to arise when empirical work is based on linear models of the relationship between the market value of equity and its determining variables. We also demonstrate how one can expand equity valuation models in terms of an infinite series of 'orthogonal' polynomials and thereby determine the relative contribution which the linear and non-linear components of the relationship between equity value and its determining variables make to overall equity value. This procedure shows that non-linearities in equity valuation can be large and significant, particularly for firms with low earnings-to-book ratios or where the undeflated book value of equity is comparatively small. Moreover, it is highly unlikely the simple linear models that characterise this area of accounting research can form the basis of meaningful statistical tests of the relationship between equity value and its determining variables.
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Non-Linear Equity Valuation
(ProQuest: ... denotes formulae omitted.)
1. IntroductionTheoretical developments in capital investment analysis show that real options can play an important role in the capital budgeting process. If a firm has the option of abandoning a poorly performing capital project it can increase the capital project's value well beyond the traditional benchmark given by the present value of its expected future cash flows; likewise, the growth option associated with an unexploited capital project can also be significant when compared with the expected present value of its future cash flows. Moreover, it is now generally accepted that these option values mean that evaluating capital projects exclusively in terms of the present values of their future cash flows can lead to seriously flawed investment decisions - highly profitable capital projects can be overlooked and poorly performing capital projects wrongly implemented. Given this, it is somewhat surprising that both empirical and analytical work on the relationship between equity value and its determining variables continues to be based on models that establish the value of a firm's equity exclusively in terms of the present value of its future operating cash flows and which, therefore, ignore the real option effects associated with the firm's ability to modify or even abandon its existing investment opportunity set. The Ohlson (1995) model, for example, from which much of the empi...See the full content of this document
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