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Keywords:

  • Equity valuation;
  • Residual income model;
  • Value-to-book ratio;
  • Accounting conservatism

Abstract

This study develops a methodology that improves the implementation of the residual income model (RIM) using the value-to-book (V/B) ratio. We decompose a firm's V/B into two components – industry V/B, estimated using the industry mean price-to-book ratio and firm-specific V/B, estimated as the difference between firm V/B and industry V/B. This approach allows us to control for the effects of accounting conservatism at the industry level, and mitigates the bias typically associated with the use of analysts' earnings forecasts in implementing the RIM. We find that a trading strategy using our fundamental value measure derived from the decomposition of the V/B ratio yields higher returns than that of prior studies' RIM implementation methods relying on analysts' forecasts, particularly for industries or firms with high levels of accounting conservatism. Further results reveal that our valuation measure predicts future returns better than traditional price multiple methods (such as the price-earnings-growth or PEG measure).