A Fundamental Analysis Approach to Oil and Gas Firm Valuation

Most fundamental analysis studies have focused on fundamentals selected by a data-driven approach on large samples of firms from numerous industries. This paper reports the results of a fundamental analysis of a single industry, the US oil and gas exploration and production industry, using variables identified by industry financial analysts. The results demonstrate a significant relationship between a number of the fundamentals with both the market value of equity and cumulative stock return. The results also suggest that the fundamentals provide incremental information beyond earnings, change in earnings, and book value of equity when explaining equity values and stock returns.     

The Transitory Nature of Negative Earnings and the Implications for Earnings Prediction and Stock Valuation

The value-irrelevance of losses largely results from the transitory nature of losses and the diminished relationship between current and future earnings. This study develops a sales-based model of future normal earnings that is useful in analyzing future earnings prospects of loss firms. Results indicate that the developed model is associated with future earnings realizations and current stock price and is shown to be incrementally value-relevant (with book value) in price regressions for loss firms. Investigation of the relative valuation role of the prediction model provides evidence that the model is associated with equity value for loss firms expected to survive.     

The Role of Earnings and Book Values in Pricing Stocks: Evidence from Turkey

In this study, we examine factors associated with equity valuation in a newly emerging market, Turkey. In the United States and other developed countries, research indicates that both earnings and book value are important predictors of equity valuation. In Turkey, earnings appears to have information content but earnings, by itself, appears to be declining in importance over time. Book value adjusted for inflation has a stronger association with equity values. In the inflationary and risky environment of Turkey, where future value of earnings is quite uncertain, investors may be paying less attention to earnings and more attention to book values. With respect to the role of book value there are competing explanations. While some researchers conclude that it is only important because it is a control for scale differences, (Barth & Kallapur 1996) others conclude that it is relevant as a proxy for normal earnings (Ohlson, 1995). Still others conclude that it is only relevant in the valuation of loss making and generally unsuccessful firms (Berger, Ofek & Swary 1996; urgstahler & Dichev, 1997). The additional contribution of this study is to show that book value is also important as a value proxy for firms operating in environments where there is rampant inflation. Our study also indicates that, overall, earnings and inflation-adjusted book values combined virtually explain almost 75% of the variation in equity prices in Turkey.     

Earnings and Equity Valuation in the Biotech Industry: Theory and Evidence

We examine how the price-earnings relation varies with the uncertainty about and the quality of a firm's investments. We develop a real option valuation framework to capture investment and abandonment options in the research-intensive biotechnology industry. We hypothesize that the price-earnings relation will be V-shaped and change over the firm 's life cycle. We also show how nonfinancial information affects the pricing of earnings. Our empirical findings are based on a sample of 301 biotechnology firms that made IPOs between 1980 and 2000, and are generally consistent with our predictions.     

Corporate Social Performance,Competitive Advantage,Earnings Persistence and Firm Value

In this paper, using a generalised valuation framework inspired by Ohlson, we show that corporate social performance (CSP) is value relevant and that, in particular, it appears to be associated with a higher coefficient on earnings. This could be attributable to either a lower cost of equity for these firms, or greater earnings persistence. We show that, once industry membership is controlled for, any cost of capital effect is minimal. Regression tests based on realised earnings confirm that the valuation effect is attributable mainly to greater earnings persistence in firms with higher levels of CSP. These outcomes are consistent with higher CSP conferring a competitive advantage on firms.     

An Empirical Evaluation of Investment Income under the Equity Method of Accounting

This study investigates the valuation implications of equity method earnings among Chinese listed firms, which are often perceived by the Chinese business press of employing the equity method to avoid reported losses. Our results show that firms with declining core earnings are more likely to have equity method investments than firms with increasing core earnings. Also, firms with lower core earnings report higher equity method earnings. Moreover, equity method earnings do not improve earnings persistence but are found to be relevant. Investors act as if they naively fixate on equity method earnings. A portfolio constructed on the basis of core earnings and equity method earnings generates a hedged return of 8%.     

An International Analysis of Historical and Forecast Earnings in Accounting-Based Valuation Models

Abstract:  In this paper we examine whether the valuation properties of historical accounting amounts, namely earnings and equity book value, differ from those of forecasted earnings for firms in 17 developed countries classified into six accounting regimes. We compare the performance of a historical model and a residual-income forecast model for explaining security prices. The historical model uses the book value of equities and actual historical earnings and the forecast model uses the book value of equities and analysts' forecasts of earnings in the residual income for estimating the intrinsic value of the firm. The results suggest that book values, historical earnings or forecasted earnings are value relevant in most regimes and countries examined. The forecast model offers significantly greater explanatory power for security prices than the historical model in the Anglo-Saxon and North American countries, Japan, Germany, and three Nordic countries. The explanatory power of the historical model is similar to that of the forecast model in the Latin countries, two Nordic countries, and Switzerland. We find that the forecast model performs similarly to the historical model where financial analysts' forecasts are noisy and analysts are less active. Further results indicate that the forecasted earnings are more value-relevant than the historical earnings in countries with stronger investor protection laws, less conservative GAAP, greater income conservatism, and more transparent accounting systems.     

Searching for value relevance of book value and earnings: a case of premium versus discount firms

We examine the premium/discount firm characteristic that fundamentally affects the value relevance of two key accounting line items, earnings and book values. We argue that from the perspective of both the residual income and option-style valuation models, the relative valuation roles of earnings and book values differ fundamentally between firms that trade at a premium vis-à-vis discount to book value. We find that book values play a significantly more important role in equity valuation than earnings when firms trade at a discount. We also find that other known influential conditions, such as the sign of earnings (Collins et al. in Acc Rev 74(1):29–61, 1999) or the relative levels of earnings and book value (Burgstahler and Dichev in Acc Rev 72(2):187–215, 1997), become inconsequential when the premium/discount condition of the firm is controlled for. The discovered relationships between the relative valuation roles of book values and earnings and the discount/premium characteristics of the firm are robust to the effect of time, information environment and the industry of the firm.     

Accruals Management to Avoid Losses

This study examines whether firms engage in accruals management to beat the zero earnings benchmark from the perspective of earnings per share (EPS). Based on net income scaled by lagged market value of equity (E/MV) to define just‐miss and just‐beat test bins, previous studies provide no or inconclusive evidence of accruals management to beat the zero earnings benchmark. I conjecture that because managers focus on shares scaled earnings performance rather than market value scaled earnings performance, forming test bins based on EPS instead of E/MV is a better approach to detect accruals management. As expected, I find evidence of accruals management to beat the zero EPS benchmark. I also find that firms are more likely to manipulate accruals when managers have stronger incentives to beat the zero EPS benchmark. In addition, accruals of firms just beating the zero EPS benchmark are more likely to reverse the next year, resulting in relatively lower future earnings for firms just beating the benchmark compared with firms just missing the benchmark.     

A Required Yield Theory of Stock Market Valuation and Treasury Yield Determination

Stock market valuation and Treasury yield determination are consistent with the Fisher effect (1896) as generalized by Darby (1975) and Feldstein (1976) . The U.S. stock market (S&P 500) is priced to yield ex-ante a real after-tax return directly related to real long-term GDP/capita growth (the required yield ). Elements of our theory show that: (1) real after-tax Treasury and S&P 500 forward earnings yields are stationary processes around positive means; (2) the stock market is indeed priced as the present value of expected dividends with the proviso that investors are expecting fast mean reversion of the S&P 500 nominal growth opportunities to zero. Moreover, (3) the equity premium is mostly due to business cycle risk and is a direct function of below trend expected productivity, where productivity is measured by the growth in book value of S&P 500 equity per-share. Inflation and fear-based risk premia only have a secondary impact on the premium. The premium is always positive or zero with respect to long-term Treasuries. It may be negative for short-term Treasuries when short-term productivity outpaces medium and long run trends. Consequently: (4) Treasury yields are mostly determined in reference to the required yield and the business cycle risk premium; (5) the yield spread is largely explained by the differential of long-term book value per share growth vs. near term growth, with possible yield curve inversions. Finally, (6) the Fed model is partially validated since both the S&P 500 forward earnings yield and the ten-year Treasury yield are determined by a common factor: the required yield.     

Dividends,research and development expenditures,and the value relevance of book value for UK loss-making firms

We extend prior research on the value relevance of accounting information for loss-making firms by allowing the coefficient of book value to vary across three distinct set of loss-making firm observations in our valuation model. Our key findings are, first, that book value is a less important determinant of equity value for either high R&D-intensive firms or dividend-paying firms, relative to firms with low R&D-intensity and zero dividends. Prior literature suggests that book value is a strong indicator of firm value for loss-making firms. This reasoning stems from book value's role as: (i) a proxy for the value of the possibility of abandoning or adapting the firms' net assets; and/or (ii) a proxy for expected future normal earnings. Our work suggests that this prior literature does not fully capture the valuation role of book value for loss-making firms. Second, we also find that dividends are value relevant, but generally only when the valuation role of book value is contextualised by allowing its coefficient to vary across high R&D-intensive firms, and dividend-paying, loss-making firms.     

Linear Information Dynamics,Dividend Irrelevance,Corporate Valuation and the Clean Surplus Relationship

This paper adopts the linear information dynamics framework pioneered in Ohlson (1979) and Garman and Ohlson (1980) (and subsequently used in, in particular, Ohlson, 1989, 1995 and Feltham and Ohlson, 1995) for thinking about desirable properties of earnings numbers in the context of the market valuation of firms, where such valuations are fundamentally based on expected future dividends. The first purpose of this paper is to consider the valuation-relevance of clean surplus earnings when there are two distinct components of clean surplus earnings whose evolutions are governed, along with book value and dividends, by a system of linear information dynamics, and dividend irrelevancy holds. The system of linear information dynamics assumed ensures that corporate value is a linear combination of the two components of clean surplus earnings, book value and dividends. One question becomes—under what circumstances are clean surplus earnings (combined with book value and dividends) sufficient for corporate valuation without a knowledge of the breakdown of clean surplus earnings into its separate components? This paper develops the conditions defining these circumstances. At the other extreme, another question can be asked—under what circumstances is one component of clean surplus earnings irrelevant to corporate valuation? This paper identifies some conditions that identify these latter circumstances. The second purpose of the paper is to identify implications of these results for both the traditional arguments about the desirability of measuring earnings on a clean surplus basis and also the more contemporary issues surrounding FRS3. A third purpose is to discuss the implications of the overall analysis for the empirical testing of the relationship between market prices and earnings numbers, and for empirically-justified definitions of maintainable earnings.     

Equity Valuation Using Multiples

We examine the valuation performance of a comprehensive list of value drivers and find that multiples derived from forward earnings explain stock prices remarkably well: pricing errors are within 15 percent of stock prices for about half our sample. In terms of relative performance, the following general rankings are observed consistently each year: forward earnings measures are followed by historical earnings measures, cash flow measures and book value of equity are tied for third, and sales performs the worst. Curiously, performance declines when we consider more complex measures of intrinsic value based on short-cut residual income models. Contrary to the popular view that different industries have different "best" multiples, these overall rankings are observed consistently for almost all industries examined. Since we require analysts' earnings and growth forecasts and positive values for all measures, our results may not be representative of the many firm-years excluded from our sample.     

Ownership structure and the pricing of discretionary accruals in Japan

This paper examines the valuation effect of discretionary accruals for Japanese firms, taking into account the book value of equity. Consistent with US evidence, the Japanese market prices discretionary accruals, indicating that discretionary accruals enhance the value relevance of reported earnings. This value relevance is lower for cross-held firms, consistent with the view that cross-business shareholding aggravates tunneling or managerial opportunism through discretionary accounting choices. On the other hand, foreign shareholding and bond financing provide effective monitoring on managerial discretion of profit firms to enhance the valuation of discretionary accruals.     

Differences in the valuation of earnings and book value: Regulation effects or industry effects?

This paper uses a valuation framework on a sample of firms from four European countries (France, Germany, Netherlands, and United Kingdom) to examine how income, accruals, and book value of equity are perceived by the respective capital markets. Our model includes adjustments for industry effects and taking into account the linear information dynamics of the accounting variables posited in the Ohlson model. Consistent with previous researchers, we find that both earnings and book value of equity have valuation implications and that there is significant dispersion in the country-specific and industry-specific valuation multiples. However, when using accounting variables to forecast market values we find that industry-specific valuation multiples reduce forecasting error more than country-specific ones.     

Conservatism in residual income models: theory and supporting evidence

In this paper, we develop a framework for evaluating the impact of conservative accounting on the structure of residual income models of equity valuation. We explore specific examples of both unconditional and conditional conservatism and observe a common mathematical structure. We proceed to generalise our model and identify the joint dependency of conservatism and the persistence of abnormal earnings on the weights attached to book values, earnings and dividends. We are able to show theoretically the likely numerical impact of conservatism on price-earnings ratios and under-valuations produced by residual income models. We investigate empirically the interaction between conservatism and persistence and find they accord well with the theory developed. We briefly discuss the implications of testing the effect of conservatism on valuation and linear information dynamics.     

Relative valuation of U.S. insurance companies

This study examines the accuracy of relative valuation methods in the U.S. insurance industry, using price as a proxy for intrinsic value. The approaches differ in terms of the fundamentals used, the adjustments made to the fundamentals, the use of conditioning variables, and the selection of comparables. Selected findings include the following. First, over the last decade, book value multiples have performed significantly better than earnings multiples in valuing insurance companies. Second, inconsistent with the practice of many analysts, excluding accumulated other comprehensive income from book value worsens rather than improves valuation accuracy. Third, as expected, using income before special items, instead of reported income, improves valuation accuracy, but, surprisingly, excluding realized investment gains and losses does not. An exception to this latter result occurred during the financial crisis, likely due to an increase in “gains trading.” Fourth, conditioning the price-to-book ratio on return on equity significantly improves the valuation accuracy of book value multiples. Finally, while valuations based on analysts’ earnings forecasts outperform those based on reported earnings or book value, the gap between the valuation performance of forecasted EPS and the conditional price-to-book approach was relatively small during the last decade.     

Valuation of Family Firms: The Limitations of Accounting Information

This conceptual paper explores the extent to which reported accounting information captures unique family firm decision‐making and intangible asset factors that impact financial value. We review the family firm valuation‐relevant literature and identify that this body of research is predicated on the assumption that accounting information reflects the underlying reality of family firms. This research, however, fails to recognise that current accounting technology does not fully recognise the family firm factors in the book value of the firm or the implications for long‐run persistence of earnings. Thus, valuation models underpinning the extant empirical research, which are predicated on reported accounting information, may not fully reflect the intrinsic value of family firms. We present propositions on the interaction between accounting information, family factors and valuation as a road map for future empirical research with a discussion of appropriate methodologies.     

Conservatism, Growth and the Role of Accounting Numbers in the Fundamental Analysis Process

I evaluate the effects of conservative accounting for research and development (R&D) and past growth in R&D on: (1) the relation between aggregate earnings (deflated by price) and contemporaneous stock return, and (2) the association between estimates of value derived from the residual income valuation model (i.e., RIV estimates) and equity market value. I show that the conservative treatment of R&D affects the earnings/return relation only for firms that experience high growth in R&D during the return interval of interest. I also demonstrate that the effect of conservative accounting for R&D on the association between RIV estimates and equity market values is increasing in past growth in R&D.This revised version was published online in August 2005 with a corrected cover date.     

Accruals,Cash Flows,and Equity Values

We find, as predicted, that the differential ability of accrual and cash flow components of earnings to help forecast future abnormal earnings and the persistence of the components result in the components having different valuation implications. We base our tests on Ohlson (1999) applied to fourteen industries. We find: (1) Accruals and cash flows aid in forecasting future abnormal earnings incremental to abnormal earnings and equity book value. (2) Accruals and cash flows provide explanatory power for equity market value incremental to equity book value and abnormal earnings. (3) There is evidence that accruals and cash flows valuation coefficients are consistent with the Ohlson model.