An Empirical Investigation of The Accounting Valuation Models

Journal of Accounting, Finance & Management Strategy, Vol. 7, No. 1, March.
2012, pp45-68
An Empirical Investigation of the Accounting Valuation Models
Shih-Cheng Lee1* Chun-Huei Lai1
Received: 30 September 2011 / Received in revised: 23 October 2011 / Accepted: 06 February 2012
Abstract
Ohlson (1995) and Feltham and Ohlson (1995, 1996) are residual income
models. These models provide a rigorous structure to examine the market value by
current accounting data. Ignoring other information, Ohlson (1995) uses the book
value and residual income to explain the firms value. Feltham and Ohlson (1995)
increases operating assets, financial assets and operating earnings to consider the
growth of abnormal earnings and accounting conservatism. Feltham and Ohlson
(1996) uses NPV concept to explain the relationship between the firms value and
accounting information and considers the effect of the depreciation policy. Based on
the value relevance of accounting number, this research wants to compare the three
models. To solve the nonstationarity problem, this research uses cointegration
approach to examine these models. The result reports that the performance of
Feltham and Ohlson (1995) is the best than Ohlson (1995) and Feltham and Ohlson
(1996). To avoid the spurious regression, this research uses the method of Gallant,
Rossi, and Tauchen (1992) to covert nonstationary variables to stationarity and
examines the explained ability of models. And the result is consistent with the
cointegration approach. The result of this research suggests the accounting
information of Feltham and Ohlson (1995) is the most relevant of the firms value.
Keywords: Residual Income Model, Cointegration, Ohlson (1995), Feltham and

Ohlson (1995), Feltham and Ohlson (1996)
JEL Classification: M41, G12
1
College of Management Yuan Ze University.
* Corresponding author, E-mail address: sclee@saturn.yzu.edu.tw
45
Journal of Accounting, Finance & Management Strategy, Vol. 7, No. 1, March. 2012, pp45-68
1. Introduction
In 1990s, there has been the literature concerned with the relationship between
firm value and accounting data based on earnings and dividends. Until the median of
1990s, there have been mature models regarding earnings and dividends. Ohlson
(1995) uses the clean surplus relation (CSR) and explains the firm value by the book
value, residual income, and other information. Residual income is the difference
between accounting earnings and normal earnings. Feltham and Ohlson (1995)
expands the model of Ohlson (1995) and considers the operating assets and financial
assets. And Feltham and Ohlson (1996) explains the firm value by cash flows and
brings the depreciation policy that havent been considered before into the model.
There are three basic models based on the residual income model (RIM).
The period between the ending of the 1990s and the beginning of the 2000s had a
number of attempts to validate the three models. Dechow et al (1999) supports the
Ohlson (1995) that the linear information dynamics is usefulness. Callen and Morel
(2001) examines the Ohlson (1995) model ignoring the other information and
supports the validity of the model. Callen and Morel (2005) supports the Feltham and
Ohlson (1995) model and finds that the other accurate information can increase the
explained ability of the model. And Ahmed et al. (2000) uses original Feltham and
Ohlson (1996) model, and finds parameters of the model is significantly consistent
with assumptions of Feltham and Ohlson (1996).
In last decade, the literature has focus on the application of the linear information
dynamics and found the other important information that can explain the market value.
For example, Barth et al (1999) finds accruals and cash flow, Hand and Landsman
(2005) finds dividends, Callen and Morel (2005) finds research and development
expenses, Brown and Caylor (2006) finds audit fees, and Lee and Lin (2010) finds
corporate governance variables. However, few studies have compared the Ohlson
(1995), Feltham and Ohlson (1995, 1996) models. Mayers (1999) derives four linear
information models from Ohlson (1995), Feltham and Ohlson (1995, 1996), but it
focuses on examine whether the linear information models are usefulness. And a little
part of Mayers (1999) compares the accuracy of estimated firms value using linear
information models with the simple model that explains the firms value only by the
book value.
The important contribution of Ohlson (1995), Feltham and Ohlson (1995, 1996)
has provided a rigorous structure to examine the relationship with current accounting
data and the market value. These three models all explore the association between
accounting data and the market value following the present value of expected
dividends (PVED) model but they consider different accounting information. Ignoring
46
other information, Feltham and Ohlson (1995) increases operating assets, financial
assets and operating earnings to consider the growth of abnormal earnings and the
accounting conservatism than Ohlson (1995). Feltham and Ohlson (1996) uses NPV
concept to explain the relationship between the firms value and accounting
information and considers the effect of the depreciation policy. Ohlson (1995),
Feltham and Ohlson (1995, 1996) consider different accounting information and
develop different models. Ohlson (1995) model includes the book value and abnormal
earnings. Feltham and Ohlson (1995) includes the book value, abnormal operating
earnings, and operating assets. Feltham and Ohlson (1996) includes the ending
operating assets, abnormal operating earnings, the beginning operating assets, and the
capital investment. And based on the value relevance of accounting number, the
model that considers relevant accounting information which have more predictive
value will be better to explain the firms value. So the purpose of this research is to
find which model is the best. And this research expects that the result will contribute
to the application of accounting valuation models.
Recently, the cointegration approach has been applied to the field of accounting.
There have been nonstationary accounting variables. Wu, Kao and Lee (1996),
Mayers (1999) all find there are nonstationary variables in their accounting models.
And nonstationariy variables lead to the spurious regression which makes high
R-square and significant statistics even if there is no economic relationship between
variables. Thus, Qi, Wu, and Xiang (2000) uses the unit root test of Phillips and
Perron (1988) to examine time-series properties of accounting variables in
Ohlon(1995) model.
This research uses time-series data. To solve the nonstationarity problem, this
research uses cointegration test which examine the long-term relationship between
two variables to examine three models. Mayers (1999) suggests parameters of three
linear information models arent consistent with assumptions because the time series
data is nonstationary. And this research tests conintegration with firm-by-firm. If one
of three models has most cointegrated firms, the model is the best to estimate the firm
value. Then, let the result is robust. This research also runs regressions of models to
compare the explained ability ( adj. R 2 ) of three models. To solve the spurious
regression problem, using the method of Gallant et al. (1992) covert nonstationary
variables to stationarity. Finally, the result of this research supports Feltham and
Ohlson (1995). Feltham and Ohlson (1995) model has most cointegrated firms and
highest explained ability. It represents the accounting information of Feltham and
Ohlson (1995) is the most value relevance.
Section 2 is literature review that introduces Ohlson (1995), Feltham and Ohlson
47
(1995, 1996) models. Section 3 shows sample section and variable measurement.
Section 4 expresses the research design. Section 5 reports the result. And the
conclusion is in section 6.
2. Literature Review
2.1 The Ohlson (1995) Model
The Ohlson (1995) has three straightforward assumptions that formulate the
valuation model. First, the market value determines as the present value of expected
dividends (PVED). If risk-free rates satisfy a nonstochastic and flat term structure, the
first assumption as follows:

MVt = R f Et [ dt + ] (a1)
=1
MVt : the market value, or price, of the firm's equity at time t.

d t + :net dividends paid at time t.
R f : the risk-free rate plus one.
Et [.] : the expected value operator conditioned at time t information.
The second assumption is the clean surplus relation (CSR). Its a relatively
general framework that the ending book value depends on earnings and the beginning
book value in addition to current dividends.
BVt = BVt - 1 + NI t - d t (a2)
BVt :net book value at time t.
NI t :earnings for the period from time t - 1.
The accounting data satisfy the clean surplus relation, and dividends reduce the
book value but dont affect current earnings.
Then, define residual income as current earnings minus the risk-free rate times
the beginning book value.
RI t = NI t - ( R f - 1) BVt - 1 (a3)
RI t :residual income for the period from time t - 1.

Combining with the equation (a3) and the clear surplus restriction, the definition
implies following equation:
d t = BVt - RI t - R f BVt (a4)
Using the equation (a4) to replace dividends in the equation (a1) to yield the
equation:
48

MVt = BVt + R f E [ RIt + ] (a5)
=1
The equation (a5) indicates that a firms value defines by its book value and the
present value of the anticipated residual income. And the future profitability can be
measured by the present value of the anticipated residual income that represents a
sequence of the difference between market value and book value. The difference
between the market value and the book value is the unrecorded goodwill. Therefore,
the future profitability is also equal to the unrecorded goodwill.
The third assumption is linear information dynamics (LID). Residual income is
stochastic time-series and it satisfies linear information dynamics as follows:
RI t +1 = RI t + vt + 1t +1
(a6)
vt +1 = vt + 2t +1
vt :information other than residual incomes
1t +1 , 2t +1:unpredictable, mean-zero disturbance terms, E t [%kt + ] = 0, k = 1, 2 and 1.
, : the fixed persistence parameters that are non-negative and less than one.
Then using the equation (a3) and the equation (a6), the anticipated next-period
earnings can be predicts by residual income as follows:
[ ]
~
Et NI t = ( R f 1) BVt + RI t + vt (a7)
Ohlson (1995) uses the first and second assumptions to yield the equation (a5)
then evaluates the present value of the anticipated residual income by the third
assumption. Finally, Ohlson (1995) derives the linear valuation function:
MVt = BVt + 1 RI t + 2vt (a8)

1 = 0
(Rf )

2 = >0
( R f )( R f )
The valuation function represents the market value as measured by the book
value and the current profitability. The current profitability is estimated by residual
income and other information that can predict the future profitability. The coefficient
1 is nonnegative value and 2 is larger than zero. This is a special case of the third
assumption. If the current residual income is sufficient to predict the future residual
income that represents vt 0 , residual income can determine goodwill. The
coefficients are positive that represent > 0 because the expected future residual
income is positive relationship with residual income and other information. The
particular situation is = 0 . It implies the expected residual income is independent
with residual income and the market value cant be explained by residual income.
49
Final, if , were large, the market value is significant relationship with residual
income and other information.
2.2 The Feltham and Ohlson (1995) Model
This model is derived from Ohlson (1995). The difference between Ohlson (1995)
and Feltham and Ohlson (1995) is that Feltham and Ohlson (1995) explains the
relationship with the market value and accounting data according to operating and
financial activities. It defines that the book value is divided into financial assets and
operating assets. Earnings are equal to interest revenues plus operating earnings.
BVt = FAt + OAt (b1)
NI t = it + oxt (b2)
FAt :financial assets at time t.
OAt :operating assets at time t.
oxt :operating earnings for the period from time t - 1.
it :interest revenues, net of interest expenses for the period from time t - 1.
There are three assumptions of Feltham and Ohlson (1995).The first assumption
is the same as Ohlson (1995). The firms market value equals to the present value of
expected dividends.
Second, accounting data satisfy the clean surplus relation (CSR), the net interest
relation (NIR), the financial assets relation (FAR) and the operating asset relation
(OAR). The book value, earnings, and dividends follow the clean surplus relation
(CSR). And the net interest relation is following:
it = ( R f - 1) FAt - 1 (b3)
R f is one plus the risk-free rate. It represents the economic return on financial
assets. For the financial assets relation, the ending finical assets increase by interest,
cash from operating activities, and decrease by dividends. The interest is earned on
financial assets. The financial assets relation is as follow:
FAt = FAt - 1 + it - [ dt - cot ] (b4)
d t :net dividends paid at time t.

cot :cash flows realized from operating activities at time t.
( d t cot ) represents that dividends and cash from operating activities directly
affect the ending financial assets. And they dont influence interest revenues during
the period. Combining with the clean surplus relation (CSR) and the financial assets
relation (FAR), accounting measurements conform to the operating asset relation
50
(OAR):
OAt = OAt - 1 + oxt - cot (b5)
Using NIR and FAR, the definition implies following equation:
d t = cot + R f FAt - 1 - FAt (b6)
Take the equation (b6) into the PVED:

MVt = FAt + R f E t [c~ot + ] (b7)
=1
The present value of expected dividends is equal to the financial assets plus the
present value of the anticipated cash flows from operations. Then abnormal operating
earnings equal to operating earnings minus the risk-free rate times the beginning
operating assets:
oxta oxt ( R f 1)oat 1 (b8)
oxta :abnormal operating earnings for the period from time t - 1.
And replacing the cash flows from operation of the equation (b7) by the equation
(b9) that is derived from OAR and definition of abnormal operating earnings, results
are following:
cot = oxta + R f OAt - 1 - OAt (b9)

[
MVt = BVt + R f E t o~xta+ ] (b10)
=1
The market value is defined by the book value and the present value of the
anticipated abnormal operating earnings.
The third assumption is the linear information model (LIM). It assumes that all
information obey the Markovian process and is presented with linear recursive
equations.
oxta+1 = 11oxta + 12OAt + 1t + 1t +1

OAt +1 = 22OAt + 2t + 2t +1
(b11)
1t +1 = 12t + 3t +1
2t +1 = 22t + 4t +1
1t , 2t :information other than operating assets and abnormal operating earnins.

kt +1 , k = 1,..., 4:unpredictable, mean-zero disturbance terms, E t [%kt + ] = 0, k = 1,..., 4 and 1.
The LIM implies three dynamic characteristics that is persistence in abnormal

operating earnings, conservatism in the accounting for operating assets, and growth in
51
operating asset associated with abnormal operating earnings and operating assets. 11
stands for persistence of abnormal operating earnings. It should satisfy 0 11 < 1
that avoids implausible persistence and shows positive persistence which decays
along with time. And 12 1 excludes aggressive accounting. The restriction of 12
is consistent with the real world accounting. Growth in operating assets are
characterized by 22 . It limits the long-run growth in operating assets by
1 22 < R f . Finally, k < 1, k = 1, 2 represents other information dont have
long-run effect.
Rearrange the equation (b11), it implies the recursive equation:
Et c% t +1 = 11oxta + ( R f 22 ) + 12 oat + [1t 2 t ] + [1t +1 2 t +1 ] (b12)
Based on the three assumptions, Felthan and Ohlson (1995) puts the equation
(b11) into the equation (b10) and finds the linear valuation function as follows:
MVt = BVt + 1oxta + 2OAt + t (b13)
11
1 =
R f 11
12 R f
2 =
(R f 22 )( R f 11 )
Rf 2
= ( 1 , 2 ) = ,
( R f 11 )( R f 1 ) ( R f 2 )
The present value of anticipated abnormal operating earnings is measured by
current abnormal operating earnings, the current book value of operating assets, and
other information that can predict future abnormal operating earnings. 1 and 2
cant be smaller than zero. 1 represents persistence of abnormal operating earnings.
If 1 > 0 , the goodwill increases related to current abnormal operating earnings. 2
stands for conservatism in the accounting for operating assets. If accounting is
conservative and the book value is underestimated, the 12 > 0 and valuation
function raises 2OAt . The conservative accounting is represented by 2 > 0 .
Especially, if the accounting is unbiased, 2 = 12 = 0 .
2.3 The Felthan and Ohlson (1996) Model
Felthan and Ohlson (1996) considers the effect of depreciation policy. The
difference between the market value and the book value depends on uncertain cash
realizations related to the depreciation policy and the effects of current events
52
including other information. And Felthan and Ohlson (1996) has three assumptions.
The first assumption is PVED. Based on Ohlson (1995), it assumes the net cash flow
is equal to the net dividend. The present value of expected dividends equals to the
present value of expected net cash flows. And it defines net cash flow equals
operating cash receipts minus investment of operating assets.
The PVED can be following:

MVt = R f Et [ ct + ] (c1)
=1
ct + :net cash flow at time t.

ct crt cit (c2)
crt :opeating cash receipts at time t.
cit :capital investmant at time t.
Second, accounting data satisfy the cash flow dynamics (CFD).1
crt +1 = crt + cit + 1t +1
(c3)
cit +1 = cit + 2 t +1
kt +1 , k = 1, 2:unpredictable, mean-zero disturbance terms, Et [%kt + ] = 0, k = 1, 2 and 1.
stands for the impact of cash investments on operating cash receipts. The
accounting data should conform to > 0 . 0 < 1 represents persistence in
operating cash receipts. 0 < R f typifies growth in capital investment.
parallels one plus the expected growth in capital investment.

To analyze the asymptotic properties of CFD, Felthan and Ohlson (1996) use
matrix method to infer the equation (c4) 2:

Et [ crt + ] = crt +
(c4)
Et [ cit + ] = cit
Substitute the equation (c4) into the equation (c1). Then:
MVt = Et [ crt + ] + Et [ cit + ] = [ crt + cit ] + [ cit ] (c5)
1
Considering other information which also affect the future cash flow, the CFD would be:
crt +1 = crt + cit + 1t + 1t +1
cit +1 = cit + 2 t + 2 t +1
1t , 2 t :information other than operating cash receipts and captial investment.

cr

E t yt + = H y t
2
let y t =
t
H = and H =
ci 0
t 0

53
1 1
R f and [ 1]
Rf
[ crt + cit ] represents the present value of future expected operating cash
receipts and [ cit ] stands for the net present value of future expected capital
investment.
To combine the depreciation policy with the model, Felthan and Ohlson (1996)
assumes that the depreciation policy should satisfy the CSR and defines abnormal
earnings are equal to operating earnings minus the risk-free rate times the beginning
operating assets. The CSR as follows:
oat +1 = oat + cit +1 dept +1 (c6)
dept +1:depreciation expense at time t.
Finally, let stands for the depreciation policy. And if PVED, CFD, and CSR
hold, the linear valuation function is following3:
MVt = oat + 1oxta + 2 oat 1 + 3cit (c7)
1 =
2 = R f ( )
Rf
3 = [ 1]
Rf
1 represents persistence in operating cash receipts. And if there are persistent

operating cash receipts > 0 , 1 should be positive. 2 stands for the joint
impact of conservatism in the accounting on operating assets and persistent
profitability. When conservative accounting holds, the parameter of operating assets is
larger than zero 2 > 0 . 2 also is influenced by persistence on operating cash
receipts. 2 would raise when raises and declines. And if more capital
investments can create more operating cash receipts > 0 , the parameter of capital
investment is positive 3 > 0 .
3. Sample Selection and Variable Measurement
3
To extend the model including other information, the linear valuation function is following:
a
MVt = oat + 1oxt + 2 oa t 1 + 3 cit + 1 1t + 2 2 t + 31t
Rf
1 = 2 =R f ( ) 3 =[ 1]
R f
1
1 = 1 R f 2 2 = 1 3 = R f 3
R f
54
All data of this research come from the Taiwan Economic Journal database(TEJ).
The sample period starts from the third quarter of 2002 to the third quarter of 2010.4
The sample includes listed companies but excludes financial companies because of
the accounting regulations are different to common industries. The final sample has
521 firms and 17193 total observations.
The market value ( MVt ) is the closing price at fiscal quarter-end date. The book
value ( BVt ) is total equity minus the preferred stock and dividends by the number of
share outstanding based on Barth et al. (1996). The financial asset is calculated as
cash and cash equivalents plus short-term investments minus current portion of
long-term debt, long-term debt and preferred stock. The operating asset ( oat ) is equal
to total equity minus financial asset and dividend by the number of share outstanding.
Capital investment ( cit ) is the change of operating assets plus the depreciation and
amortization expense.
The residual income ( RI t ) is defined as earnings minus the normal earnings.
Earnings are calculated as net income plus extraordinary items. And the normal
earnings are defined by cost of equity times the book value. The abnormal operating
earnings ( oxt ) is defined as operating earnings minus normal operating earnings. The
operating earnings follow Ahmed et al. (2000) which defines operating earnings as
earnings plus the interest expense and minus interest income and non-controlling
interest. Abnormal operating earnings are defined as the cost of equity times the
operating assets. Finally, this research uses three methods to decide the cost of equity.
First, this research assumes the fixed cost of equity 12% based on Barth et al. (1999),
and Landsman et al. (2006). Second, let cost of equity equals to the 30-day annualized
commercial paper rate because Lee et al. (1999) finds that cost of equity would follow
stock price. Third, this research use CAPM5 to calculated the cost of equity and
adjust by following method:
rt = Max ( rm , rf ) (d1)
rm : the cost of equity calculated by CAPM.

rf : the 30-day annualized commerical paper rate.
4
To avoid the conflict between discount of annual data and quarterly data, this research uses
accumulated four quarters data if the data is flow accounting number. On discount of annual data
studies use the closing price on December 31 and annual accounting data. Studies also use the closing
price on December 31 but uses quarterly accounting data on discount of the fourth quarter data. There
is a conflict on flow accounting data. So to solve the conflict, if the accounting data considers the
flow data, this research uses accumulated four quarters accounting data. For example, the earning on
the each quarter are the current quarterly earning plus past three quarterly earnings.
5
The market return of CAPM is used MSCI Taiwan index. This research also uses Taiwan Stock
Exchange Capitalization Weighted Stock Index (TAIEX). And the result is similar to MSCI index.
55
4. Research Design
4.1 Cointegration Test
Granger (1981) documents the basic concept of cointegration that two

nonstationary variables move together in the long-term but there is insignificant
relationship between two variables in the short-term. And if two time series variables
which one is dependent variable and other one is independent variable in a regression
are nonstationary which become stationary after doing the first difference, the residual
of linear regression is stationary. Then the result shows that two variables are
contegrated. And Engle and Granger (1987) follows Granger (1981) and expand the
model to estimate and test. Cointegration approach is applied in many financial fields.
Anderson et al. (1990), Barnhart and Szakmary (1991) use cointegration test to proof
the relationship of the term structure of U.S. Treasury bill, spot and forward.
So this research adopts the cointegration approach to examine the explained
abilities to three accounting valuation models and compare which model is best. The
model which has most cointegrated firms can explain most of the market value.
Following the cointegration approach, the first stage should examine whether
variables are nonstationary or not. This research uses Augmented Dickey-Fuller (ADF)
test to examine variables are stationary or not. The ADF regression as follows:
P
xt = a 0 + a1 xt 1 + i xt i + i (e1)
i =1
If the result doesnt reject the null hypothesis, the variable is nonstationary.
Second stage, the research tests the first difference of variables and expects the ADF
test of the first difference is reject the null hypothesis. First difference of variables
doesnt have a unit root. Finally, to test the relationship between the firms market
value and the accounting variables based on three accounting models and compare the
models, this research ignores other information and only tests basic accounting
valuation models. Running following regressions and using residual items of
regressions to do the ADF test. If residual items dont have a unit root that means the
test result reject the null hypothesis, regressions are cointegrated. And to compare
with the book value, this research increases the regression of the market value on the
book value. Mayers (1999) suggests the three models estimating the firms value
dont better than the book value. To the robustness result, this research also uses
different residual income and abnormal operating income.
MVt = 1 + 2 BVt + t (e2)
MVt = 1 + 2 BVt + 3 RI1t + t (e3)
MVt = 1 + 2 BVt + 3 RI 2t + t (e4)
56
MVt = 1 + 2 BVt + 3 RI 3t + t (e5)
MVt = 1 + 2 BVt + 3ox a 1t + 4OAt + t (e6)
MVt = 1oat + 2 ox a 1t + 3oat 1 + 4 cit + t (e9)
The equation (e3) to (e5) are the Ohlson (1995) models. The equation (e6) to (e8)
are Feltham and Ohlson (1995) Models. And Feltham and Ohlson (1996) Models are
the equation (e9) to (e11).
4.2 Detrend Method : Gallant, Rossi, and Tauchen (1992)
The variables of this research are nonstationary. If this research runs the
regressions of all data to compare the explanatory ability as measured by adjusted
R-square of three models, there is spurious regression which variables are
nonstationary. Gallant et al. (1992) uses a two-stage adjustment process to adjust the
Calendar effects in the mean and variance of the stock price and trading volume. And
Choedia et al. (2007) adjusts price, firm size, turnover, analyst coverage, and order
imbalances along the method of Gallant et al. (1992). So this research follows Gallant
et al. (1992) to eliminate the nonstationarity problems.
The nonstationary variables are market value( MVt ), book value ( BVt ), residual
income that the cost of equity is fixed ( RI 1t ), residual income that the cost of equity
is fixed ( RI 1t ), residual income that the cost of equity is 30-day commercial paper
rate, operating assets at time t ( oat ), operating assets at time t 1 ( oat 1 ),
abnormal operating earnings that the cost of equity is fixed ( ox a 1t ), and abnormal
operating earnings that the cost of equity is 30-day commercial paper rate ( ox a 2t ). In
Table 2 the percentage of stationarity of these variables are smaller than 50% on ADF
57
test.11 To eliminate the nonstationarity, this research sets up three quarterly dummy
variables (first quarter to third quarter) of the year and linear quarterly time-trend
variables t and t 2 . First stage, this research run following mean regression for each
variable to each firm:
w = x ' + (e1)
w:one of variables to be adjusted.
x ':a vector of one and the adjustment regressors (three quarterly dummies, t, and t 2 ).
Second stage, to standard the residuals from the mean regression, this research
takes the least squares residuals from the equation (e1) to run the following variance
regression:
log( 2 ) = x ' + (e2)
log( 2 ):natural log of the least squares residuals from the equation ( e1) .
x ':a vector of one and the adjustment regressors (three quarterly dummies, t, and t 2 ).
Finally, this research finds the adjusted variables for each firm by following
converted equation:
{
wadj = + / exp( x ' / 2) } (e3)
wadj : adjusted value of variable.

:residual items from the equation ( e1) .
x ' : the items from the equation (e2).
and are defined by the means and variances of original variable w are equal
to adjusted variable. The converted equation (e3) let the units of original variable and
variable and adjusted variable are the same.
5. Empirical Results
Table 1 reports the descriptive statistics of the sample. The average market value
is 21.42 per share. It is larger than the average book value of 16.01 per share. The
difference between the market value and the book value is the goodwill. However, the
standard deviation of market value is 31.25 which is quad times than the book value.
It represents that the book value doesnt enough to track the volatility of the market
value. There are other information affect the market value.
The average of RI 2t is the largest on residual income, because the cost of equity
uses the 30-day commercial paper rate. It is the lowest rate on three methods. And the
11
These variables which dont reject the null hypothesis is nonstationary on panel unit test.
58
standard deviation of RI 3t using CAPM is largest, because the volatility of market

return is high. The standard deviation of RI 1t is the lowest, because cost of equity is
constant. For three abnormal operating earnings, they are similar to residual income.
The average of ox a 2t is highest. And the standard deviation of ox a 3t is largest and
ox a 1t is lowest. The average operating assets of 22.92 is little higher than operating
assets t 1 .(Insert Table 1 here)
5.1 Test Result of Stationarity
To do the cointegration test, variables should be nonstationary and the first

difference is stationary. First stage, this research uses ADF test to examine whether
variables are nonstationary or not. Table 2 represents the results of ADF unit root test
without a time trend for all variables. For the market value, the average ADF statistic
is -1.66 and median is -1.76. They are all larger than the critical value -2.93 at 5%
significant level. And the first quartile(Q1) is -2.40, which is also larger than the
critical value. So the result shows that only 11.52% of the market value in the 521
firms are stationary. The average ADF statistic of the book value is -1.52 and Q1 is
-2.31. They are above the -2.93. So the stationary book value is only 12.09% on all
firms. For RI 1t and RI 2t , Percentage of stationarity are 22.46% and 21.50%. Their
mean and median are all above the critical value. However, the average ADF statistic
of RI 3t is -3.16 and median is -3.75. They are below -2.93 at 5% level. So the result
reports that there are 63.34% stationary firms of RI 3t in all firms. For abnormal
a a
operating earnings, results are similar with residual income. ox 1t and ox 2t have
a
17.85% and 21.31% stationary firms, respectively. And ox 3t is only third quartile
a
(Q3) above critical value at 5% level. There are 71.59% of ox 3t on all firms.
RI 3t and ox a 3t using CAPM to calculate the cost of equity are higher stationary. The
mean, median, and Q1 of Operating assets at t , t 1 time are all above the critical
value. There are 9.4% and 10.17% of Operating assets at t , t 1 time. And only Q3
of cit is above critical value. Percentage of stationarity is 86.37% for cit . Final, the
results of Table 2 are consistent with Mayer (1999) that the accounting data have
nonstationariy problem.(Insert Table 2 here)
Second, this research examines the first difference of all variables. Table 3
reports the result of ADF unit root test without a time trend of the first difference. The
mean, median, Q1, and Q3 of all variables are below the critical value -2.93 at 5%
significant level. First difference of nonstationary variables becomes stationary. And
stiationary extent of variables ( RI 3t , ox a 3t , cit ) become more stationary than
before.(Insert Table 3 here)
59
5.2 Test Result of Cointegration
To compare the book value, Ohlson (1995) and Feltham and Ohlson (1995,1996),
this research examines firm-by-firm to estimate the percentage of firms whose market
value is cointegrated with the accounting variables of models regarding equation (e2)
to (e11). This research examines the error terms of equation (e2) to (e11) by ADF unit
root test. If the error terms is stationarity, the model is cointegration. It means that
there is long-term relationship between the market value and the accounting data.
Table 4 reports the result of cointegration test. Panel A of Table 4 reports the
result of the equation (e2) which regress the market value on the book value. The
average ADF statistic and median of equation (e2) are -2.59 and -2.53 respectively.
They are all above the critical value -2.93 at 5% significant level. This research finds
that there is only 35.89 % of firms whose market value is cointegrated with the book
value. And Panel B reports the results of Ohlson (1995) on equation (e3) to (e5). The
cointegrated firms of Ohlson (1995) are 41.07% (or higher) on 521 firms. The mean
and Q1 are below the critical value. Panel C reports the results of Feltham an Ohlson
(1995) on equation (e6) to (e8).The cointegrated firms of Ohlson and Feltham (1995)
are 50.29% (or higher). The mean, median and Q1 are below the critical value. Finally,
Panel D reports the results of Feltham and Ohlson (1996) on equation (e9) to (e11).
The cointegrated firms of Ohlson and Feltham (1996) are 39.54% (or higher).
The percentage of cointegrated firms on three accounting models is higher than
the regression of the market value on the book value. The Ohlson (1995) and Feltham
and Ohlson (1995, 1996) estimating the firms value will be better than the book value.
It represents that the residual income, abnormal operating earnings, operating assets,
and the capital investment have the ability to explain the market value. After solving
the nonstationarity problem, the result doesnt support Mayers (1999). And the
Percentage of cointegrated firms on Feltham and Ohlson (1995) are higher than other
two models. Though this research uses different methods to calculate the cost of
equity, results are still consistent that the performance of Feltham and Ohlson (1995)
is the best. The results represents that the Feltham and Ohlson (1995) considers the
most relevant accounting information. The combination of the book value, abnormal
operating earnings, and operating assets has the strongest long-term relationship with
the market value in three models.(Insert Table 4 here)
5.3 Result of Detrend Regressions
To robustness the result, this research uses the method of Gallant et al. (1992) to
covert nonstationary variables to stationarity and runs the regressions form (e2) to
60
(e11). Because variables RI 3t , ox a 3t , and cit are stationary, they dont need to use
Gallant, Rossi, and Tauchen (1992) method to covert variables. Results of regressions
are reported on Table 5.
Panel A of Table 5 reports the regression of the market value on the book value.
The ability to explain the book value is 0.242. Panel B reports the regressions of
Ohlson (1995). The explained abilities of Ohlson (1995) models using different cost
of equity are all higher than the book value. And Panel C is results of Feltham and
Ohlson (1995). The adj R 2 of Feltham and Ohlson (1955) models are all higher than
the book value as well, and the first models of Feltham and Ohlson (1995) are
significantly better than Ohlson (1995) . Panel D reports the regressions of Feltham
and Ohlson (1996). adj R 2 of first two regressions are higher than the book value.
However, the performance of third regression, whose cost of equity calculated by
CAPM is poor. adj R 2 is even lower than the book value. Comparing with Panel D of
Table 4, the result of Feltham and Ohlson (1996) using CAPM also have lower
percentage of cointegration. And all coefficients of regressions are significantly
positive.
To compare explained abilities of three accounting models, this research finds
that Feltham and Ohlson (1995) have the highest adj R 2 even using the different
cost of equity, this result is consistent with the Table 4. Although this research cant
find that which model is the worst, the empirical results represents that Feltham and
Ohlson (1995) uses the most relevant accounting information and includes the most
predictive value, so it is the best model to explain the firms value. (Insert Table 5
here)
6. Conclusion
Based on value relevance of accounting number, this research compares with

three residual income models-Ohlon (1995), Feltham and Ohlson (1995, 1996). For
solve the nonstationarity problem, this research uses the cointegration approach to
examine the three models. To avoid the spurious regression, this research uses the
method of Gallant et al. (1992) to covert variables. Then, this research finds two
empirical results as follows:
First, three accounting model are better than the book value to estimate the firms
value. It isnt consistent with Mayers (1999). Mayers (1999) suggest that the three
linear information models can estimate the firms value better than the book value.
But this research finds that three models all perform better than the book value on
cointregation test and detrend regressions.
Second, this empirical result represents Feltham and Ohlson (1995) is the best
model than Ohlson (1995) and Feltham and Ohlson (1996). Its percentage of
61
cointregated firms is highest even considering the different cost of equity. The
explained ability of Feltham and Ohlson (1995) is also the best on three models. So it
also exhibits Feltham and Ohlson (1995) uses the most relevant accounting
information and includes the most predictive value.
This research also expects the findings have a contribution on the application of
accounting valuation models which focus on to find the other information to
explained the market value.
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62
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63
Table 1
Descriptive Statistics of the Sample
The MVt is the market value per share at the end of quarter t. The BVt is the
book value per share at the end of quarter t . RI 1t is residual income per share
calculated by income before extraordinary item minus the cost of equity r times
beginning year of the book value and assumes the cost of equity r is 12%. RI 2t
assumes the r is 30-day commercial paper rate. RI 3t assumes the r is maximum of
30-day commercial paper rate or the rate calculated by CAPM. ox a 1t is abnormal
operating earnings per share calculated by operating earnings in quarter t minus
expected normal earning which is r times last periods net operating asset and the r
assumes 12%. ox a 2t , ox a 3t are the rate of 30-day commercial paper and the
maximum of 30-day commercial paper rate or CAPM rate. oat is net operating assets
per share calculated by the book value of shareholders equity minus net financial
assets plus net deferred tax liabilities. cit is the capital investment per share at the
end of quarter t.
mean SD Q1 median Q3
MVt 21.42 31.25 8.84 13.97 23.74
BVt 16.01 8.35 11.76 14.48 18.20
RI1t -0.36 2.49 -1.42 -0.65 0.39
RI 2t 1.31 3.03 -0.04 0.88 2.20
RI 3t 0.25 3.32 -1.05 0.22 1.51
ox a 1t -1.06 2.65 -2.16 -1.23 -0.23
ox a 2t 1.32 2.98 0.00 0.90 2.19
ox a 3t -0.15 3.84 -1.37 0.09 1.38
oat 22.92 12.00 15.54 20.12 27.22
oat - 1 22.82 11.74 15.54 20.06 27.11
cit 0.68 2.64 -0.25 0.50 1.46
64
Table 2
Augmented Dickey-Fuller Unit Root Test with No Trend
This table reports the summary statistics of Augmented Dickey-Fuller unit root
test for all variables. The last column is the percentage of firms that are stationary at
5% significant level. The critical value is -2.93 at the 5% significant level.
mean SD Q1 median Q3 Percentage of Stationarity

MVt -1.66 1.35 -2.40 -1.76 -1.01 11.52%
BVt -1.52 1.47 -2.31 -1.64 -0.82 12.09%
RI1t -2.14 1.19 -2.83 -2.12 -1.44 22.46%
RI 2t -2.08 1.35 -2.77 -2.03 -1.34 21.50%
RI 3t -3.16 0.88 -3.75 -3.25 -2.57 63.34%
ox a 1t -2.12 1.04 -2.66 -2.02 -1.52 17.85%
ox a 2t -2.05 1.28 -2.71 -2.03 -1.36 21.31%
ox a 3t -3.33 0.80 -3.85 -3.44 -2.83 71.59%
oat -1.68 1.07 -2.34 -1.76 -1.09 9.40%
oat - 1 -1.74 1.23 -2.35 -1.76 -1.17 10.17%
cit -4.66 1.65 -5.69 -4.76 -3.68 86.37%
Table 3
Augmented Dickey-Fuller Unit Root Test with No Trend of the First Difference
This table reports the summary statistics of Augmented Dickey-Fuller unit root
test for the first difference of all variables. The last column is the percentage of firms
that are stationary at 5% significant level. The critical value is -2.93 at the 5%
significant level.
Mean SD Q1 median Q3 Percentage of Stationarity

MVt -5.12 1.41 -5.99 -5.08 -4.17 96.35%
BVt -4.99 1.90 -6.09 -5.26 -3.67 83.49%
RI1t -4.61 1.47 -5.46 -4.58 -3.64 89.83%
RI 2t -4.48 1.51 -5.34 -4.47 -3.52 86.37%
RI 3t -4.80 0.77 -5.19 -4.74 -4.36 98.85%
ox a1t -4.72 1.48 -5.51 -4.72 -3.78 89.25%
ox a 2t -4.45 1.55 -5.37 -4.44 -3.49 86.37%
ox a 3t -4.82 0.69 -5.19 -4.81 -4.37 99.23%
oat -5.43 1.56 -6.34 -5.44 -4.61 93.09%
oat - 1 -5.41 1.57 -6.37 -5.46 -4.61 93.67%
cit -7.38 2.40 -8.77 -7.21 -5.90 97.70%
65
Table 4
Cointegration Test for Three Accounting Models
This table reports the summary statistics of cointegration test for the regression
of the market value on the book value and three accounting models based on Ohlson
(1995), Feltham-Ohlson (1995), Feltham-Ohlson (1996). The model based on Ohlson
(1995) includes the book value at time t and residual income at time t .
Feltham-Ohlson (1995) includes the book value at time t , abnormal operating
earnings at time t , and net operating assets at time t . Feltham-Ohlson (1996)
includes the book value at time t , the abnormal operating earnings at time t , net
operating assets at time t 1 , and the capital investment at time t . For residual
income ( RI 1t , RI 2t , RI 3t )and abnormal operating earnings ( ox a 1t , ox a 2t , ox a 3t ) , cost
of equity capital is 12%, 30-day commercial paper rate and the maximum of 30-day
commercial paper rate or CAPM rate. The critical value is -2.93 at the 5% significant
level.
Percentage of
mean SD Q1 median Q3
Stationarity
Panel A
BVt -2.59 1.02 -3.24 -2.53 -1.92 35.89%
Panel B: Ohlson (1995)
RI1t -2.92 0.98 -3.48 -2.91 -2.32 49.14%
RI 2t -2.91 0.98 -3.49 -2.90 -2.31 48.18%
RI 3t -2.73 1.07 -3.36 -2.71 -2.05 41.07%
Panel C: Feltham-Ohlson (1995)
ox a1t -3.22 1.05 -3.87 -3.18 -2.58 60.46%
a
ox 2t -3.25 1.01 -3.91 -3.20 -2.63 61.80%
ox a 3t -2.99 1.13 -3.62 -2.94 -2.31 50.29%
Panel D:Feltham-Ohlson (1996)
ox a1t -2.93 1.06 -3.59 -2.95 -2.33 51.06%
a
ox 2t -2.97 1.02 -3.65 -2.96 -2.36 51.63%
a
ox 3t -2.60 1.19 -3.27 -2.68 -2.04 39.54%
66
Table 5
Regressions Analysis of Three Accounting Models
Panel A is the regression of the market value on the book value. Panel B is the
Ohlson (1995) model including the book value at time t and residual income at time
t . Panel C is the Feltham-Ohlson (1995) including the book value at time t ,
abnormal operating earnings at time t , and net operating asset at time t . Pane D is the
Feltham-Ohlson (1996) model including the book value at time t , the abnormal
operating earnings at time t , net operating assets at time t 1 , and the capital
investment at time t . The independent variable is AMVt . The AMVt is Gallant,
Rossi, and Tauchen (1992) (GRT)-adjusted value of the natural log of market value
per share at the end of quarter t . The AMVt is the GRT-adjusted value of natural log
of book value per share at the end of quarter t . AMVt is the GRT-adjusted value of
residual income per share assumes the cost of equity capital r is 12%. ARI 2t is the
GRT-adjusted value of residual income per share assumes the r is 30-day commercial
paper rate. RI 3t is the residual income per share assumes the r is maximum of
30-day commercial paper rate or the rate calculated by CAPM. Aox a 1t is the
GRT-adjusted value of abnormal operating earnings per share calculated by operating
earnings in quarter t minus expected normal earning that is r times last periods net
operating asset and the r assumes 12%. Aox a 2t is the GRT-adjusted value assumes
the r is 30-day commercial paper rate. ox a 3t is the rate of 30-day commercial paper
and the maximum of 30-day commercial paper rate or CAPM rate. Aoat is the
GRT-adjusted value of net operating assets per share. cit is the capital investment
per share at the end of quarter t.
Explanatory
ARI 1 t
variables Intercept ABVt ARI 2 t RI 3 t Aox a 1t Aox a 2t ox a 3t Aoat Aoat - 1 cit Adj.R 2 N
Panel A
Model 1 0.5893*** 0.7791*** 0.2418 17193

(20.74 ) (74.05 )
Panel B: Ohlson (1995)
Model 2 1.2254*** 0.5533*** 0.0950*** 0.3162 17193

(39.87 ) (49.08 ) (43.25 )
Model 3 1.4109*** 0.4245*** 0.0967*** 0.3330 17193
(44.68 ) (34.56 ) (48.49 )
Model 4 0.7922*** 0.6999*** 0.0302*** 0.2562 17193
(26.17 ) (61.98 ) (18.22 )
Explanatory
ARI 1 t
variables Intercept ABVt ARI 2 t RI 3 t Aox a 1t Aox a 2t ox a 3t Aoat Aoat - 1 cit Adj.R 2 N
67
Panel C :Feltham-Ohlson (1995)
Model 5 1.4115*** 0.4115*** 0.0950*** 0.0113*** 0.3358 17193

(44.97 ) (31.68 ) (46.93 ) (22.89 )
Model 6 1.3949*** 0.4049*** 0.0948*** 0.0030*** 0.3334 17193
(44.45 ) (30.88 ) (46.17 ) (6.08 )
Model 7 0.7813*** 0.6450*** 0.0168*** 0.0073*** 0.2570 17193
(25.89 ) (50.65 ) (12.06 ) (14.22 )
Panel D: Feltham-Ohlson (1996)
Model 8 2.3335*** 0.1229*** 0.0114*** 0.0084*** 0.0118*** 0.2997 17193

(203.42 ) (65.35 ) (9.92 ) (7.54 ) (5.53 )
Model 9 2.3099*** 0.1225*** 0.0050*** 0.0031*** 0.0166*** 0.2989 17193
(202.66 ) (65.17 ) (4.31 ) (2.75 ) (7.78 )
Model 10 2.2027*** 0.0341*** 0.0118*** 0.0076*** 0.0281*** 0.1533 17193
(177.39 ) (23.72 ) (9.33 ) (6.22 ) (12.03 )
68
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Journal of Accounting, Finance & Management Strategy, Vol. 7, No. 1, March.

An Empirical Investigation of the Accounting Valuation Models

Shih-Cheng Lee1* Chun-Huei Lai1

Keywords: Residual Income Model, Cointegration, Ohlson (1995), Feltham and

JEL Classification: M41, G12

2.1 The Ohlson (1995) Model

MVt : the market value, or price, of the firm's equity at time t.

RI t :residual income for the period from time t - 1.

d t = BVt - RI t - R f BVt (a4)

2.2 The Feltham and Ohlson (1995) Model

FAt = FAt - 1 + it - [ dt - cot ] (b4)

d t :net dividends paid at time t.

d t = cot + R f FAt - 1 - FAt (b6)

Take the equation (b6) into the PVED:

oxta oxt ( R f 1)oat 1 (b8)

oxta :abnormal operating earnings for the period from time t - 1.

cot = oxta + R f OAt - 1 - OAt (b9)

oxta+1 = 11oxta + 12OAt + 1t + 1t +1

1t , 2t :information other than operating assets and abnormal operating earnins.

The LIM implies three dynamic characteristics that is persistence in abnormal

1 22 < R f . Finally, k < 1, k = 1, 2 represents other information dont have

Et c% t +1 = 11oxta + ( R f 22 ) + 12 oat + [1t 2 t ] + [1t +1 2 t +1 ] (b12)

MVt = BVt + 1oxta + 2OAt + t (b13)

2.3 The Felthan and Ohlson (1996) Model

ct + :net cash flow at time t.

operating cash receipts. 0 < R f typifies growth in capital investment.

parallels one plus the expected growth in capital investment.

Substitute the equation (c4) into the equation (c1). Then:

MVt = Et [ crt + ] + Et [ cit + ] = [ crt + cit ] + [ cit ] (c5)

1t , 2 t :information other than operating cash receipts and captial investment.

MVt = oat + 1oxta + 2 oat 1 + 3cit (c7)

1 represents persistence in operating cash receipts. And if there are persistent

3. Sample Selection and Variable Measurement

rm : the cost of equity calculated by CAPM.

4.1 Cointegration Test

Granger (1981) documents the basic concept of cointegration that two

MVt = 1 + 2 BVt + 3 RI 3t + t (e5)

MVt = 1 + 2 BVt + 3ox a 1t + 4OAt + t (e6)

MVt = 1 + 2 BVt + 3ox a 2t + 4OAt + t (e7)

MVt = 1 + 2 BVt + 3ox a 3t + 4OAt + t (e8)

MVt = 1oat + 2 ox a 1t + 3oat 1 + 4 cit + t (e9)

MVt = 1oat + 2 ox a 2t + 3oat 1 + 4 cit + t (e10)

MVt = 1oat + 2 ox a 3t + 3oat 1 + 4 cit + t (e11)

4.2 Detrend Method : Gallant, Rossi, and Tauchen (1992)

wadj : adjusted value of variable.

standard deviation of RI 3t using CAPM is largest, because the volatility of market

The average of ox a 2t is highest. And the standard deviation of ox a 3t is largest and

assets t 1 .(Insert Table 1 here)

5.1 Test Result of Stationarity

To do the cointegration test, variables should be nonstationary and the first

5.2 Test Result of Cointegration

5.3 Result of Detrend Regressions

Based on value relevance of accounting number, this research compares with

[12] Engle, R. F. & Granger, C. W. J. (1987). Cointegration and error correction:

MVt 21.42 31.25 8.84 13.97 23.74

BVt 16.01 8.35 11.76 14.48 18.20

RI1t -0.36 2.49 -1.42 -0.65 0.39

RI 2t 1.31 3.03 -0.04 0.88 2.20

RI 3t 0.25 3.32 -1.05 0.22 1.51

ox a 1t -1.06 2.65 -2.16 -1.23 -0.23

ox a 2t 1.32 2.98 0.00 0.90 2.19

ox a 3t -0.15 3.84 -1.37 0.09 1.38

oat 22.92 12.00 15.54 20.12 27.22

Model 1 0.5893* 0.7791* 0.2418 17193

Model 2 1.2254* 0.5533* 0.0950*** 0.3162 17193

Model 5 1.4115* 0.4115* 0.0950* 0.0113* 0.3358 17193

Model 8 2.3335* 0.1229* 0.0114* 0.0084* 0.0118*** 0.2997 17193