Are earnings more informative than residual income in valuation models?

Abstract

The efforts to derive a theoretically correct valuation model based on accounting data has lead to the development of the Feltham and Ohlson (1995) model, which employs book values (BV) and residual income (RI) as valuation attributes. However, in empirical settings RI is often replaced by net income (NI). The present paper shows that replacing RI with NI in valuation models potentially reduces information content and significance. The results also indicate that RI has a stronger association with Market values in conjunction with Research and Development expenditures (RD) and Book value. RD is shown to enhance the explanatory power of NI and RI for market values (MV). Its inclusion in valuation models, is thus, supported by the present paper.