Equity valuation and negative earnings : The role of book value of equity

Research output: Journal Publications and ReviewsRGC 21 - Publication in refereed journalpeer-review

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Author(s)

  • Daniel W. Collins
  • Morton Pincus
  • Hong Xie

Related Research Unit(s)

Detail(s)

Original languageEnglish
Pages (from-to)29-61
Journal / PublicationAccounting Review
Volume74
Issue number1
Publication statusPublished - Jan 1999

Abstract

This study provides an explanation for the anomalous significantly negative price-earnings relation using the simple earnings capitalization model for firms that report losses. We hypothesize and find that including book value of equity in the valuation specification eliminates the negative relation. This suggests that the simple earnings capitalization model is misspecified and the negative coefficient on earnings for loss firms is a manifestation of that misspecification. Furthermore, we provide evidence on three competing explanations for the role that book value of equity plays in valuing loss firms. Specifically, we investigate whether the importance of book value in cross-sectional valuation models stems from its role as (1) a control for scale differences (Barth and Kallapur 1996), (2) a proxy for expected future normal earnings (Ohlson 1995; Penman 1992), or (3) a proxy for loss firms' abandonment option (Berger et al. 1996; Barth et al. 1996; Burgstahler and Dichev 1997). Our results do not support the conjecture that the importance of book value in cross-sectional valuation stems primarily from its role as a control for scale differences. Rather, the results are consistent with book value serving as a value-relevant proxy for expected future normal earnings for loss firms in general, and as a proxy for abandonment option for loss firms most likely to cease operations and liquidate.

Research Area(s)

  • Book value of equity, Negative earnings, Price-earnings relation misspecification

Citation Format(s)

Equity valuation and negative earnings: The role of book value of equity. / Collins, Daniel W.; Pincus, Morton; Xie, Hong.
In: Accounting Review, Vol. 74, No. 1, 01.1999, p. 29-61.

Research output: Journal Publications and ReviewsRGC 21 - Publication in refereed journalpeer-review