A note on accounting conservatism in residual income and abnormal earnings growth equity valuation

The impact of conservative accounting on residual income (RI) and abnormal earnings growth (AEG) valuation models is investigated in this note. Limiting the analyses to information dynamics constrained models (the core models in Ohlson, 1995; Ohlson & Juettner-Nauroth, 2005), we find that both models can handle accounting conservatism if the persistence factors of residual income or abnormal earnings growth fulfil certain conditions. In a comparison of permissible time-series specifications, the AEG model can potentially handle more conservatively biased earnings in the first forecast period than the RI model. However, this requires that the growth of the conservative bias in the second forecast period is not too large. In a 0-NPV competitive equilibrium with a constant steady state growth, both models work equally well. Further elaborations indicate that, in the presence of accounting conservatism a reasonable value of the persistence factor of residual income in the RI model should be in the interval between 1.0 and R (where R = 1 + discount rate), whereas the persistence factor of abnormal earnings growth in the AEG model should be close to 1.0. This implies that the persistence factor in the RI model appears to have been understated while the persistence factor in the AEG model appears to have been overstated in previous empirical research.