What Determines Residual Income

By Qiang Cheng. 2001

133 citations recorded by the source corpus.

This paper investigates the determinants of residual income scaled by book value of equity, i.e., abnormal return on equity (ROE), by analyzing the impact of value‐creation (economic rents) and value‐recording (conservative accounting) processes on abnormal ROE. I rely on economic theories to characterize economic rents and develop an empirical measure—the conservative accounting factor—to capture the effect of conservative accounting. As expected, industry abnormal ROE increases with industry concentration, industry‐level barriers to entry, and industry conservative accounting factors. Also as expected, the difference between firm and industry abnormal ROE increases with market share, firm size, firm‐level barriers to entry, and firm conservative accounting factors. Integrating these determinants into the residual income valuation model significantly increases its explanatory power for the variation in the market‐to‐book ratio.

Subfields: Accounting, Strategy and Management

View Paper: https://www.semanticscholar.org/paper/efcff3447e015eccfa809c9f049fad2f4e4bb289

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Citations in the corpus

The Effect of Research and Development (R&D) Inputs and Outputs on the Relation between the Uncertainty of Future Operating Performance and R&D Expenditures (2011, background): “Literature on the value relevance of other nonfinancial measures includes Ittner and Larcker (1998); Behn and Riley (1999); Trueman, Wong, and Zhang (2000); Demers and Lev (2001); Bartov, Mohanram, and Seethamraju (2002); and Cheng (2003).”
Taking the Pulse of the Real Economy Using Financial Statement Analysis: Implications for Macro Forecasting and Stock Valuation (2014, background): “Profit margin, the ratio of operating income after depreciation to sales, can be further decomposed into the ratio of operating income before depreciation to sales, or operating margin (OM), and the ratio of depreciation to sales (DEP), a proxy for tangible capital intensity (Lev 1983; Cheng 2005).”
Business Strategy, Financial Reporting Irregularities, and Audit Effort (2013, background): “HERF = Herfindahl Index (based on Cheng 2005) equal to the sum of squares of market shares of all companies in an industry (three-digit SIC) where market share equals the company with sales in time t divided by sum of (sales)t over the three-digit SIC industry, where the higher the Herfindahl…”
Proactive R&D management and firm growth: A punctuated equilibrium model (2011, background): “Finally, here is considerable evidence that firm performance increases as ndustry concentration increases (Mudambi and Navarra, 2004; heng, 2005).”
The Limitations of Industry Concentration Measures Constructed with Compustat Data: Implications for Finance Research (2009, unknown): “…2008 The Review of Financial Studies / v 22 n 10 2009 (Harris 1998; Botosan and Harris 2000; Botosan and Stanford 2005; Rogers and Stocken 2005; Verrecchia and Weber 2006), income-increasing accounting choices (Zmijewski and Hagerman 1981), and the determinants of corporate earnings (Cheng 2005).”