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Residual Income Valuation and Current Cost Accounting
David Ashton, University of Bristol
Ken Peasnell, University of Lancaster
Pengguo Wang, Imperial College London
ABSTRACT. Existing empirical evidence suggests that residual income valuation models based on historic cost accounting considerable underestimate equity values. It has also been established that inflation plays no specific role the valuation structures that arise from the residual income reformulation of the dividend valuation model. This paper explores these apparently contradictory results. We examine the role of inflation in residual income valuation using both simulation and theoretical models. We show that although the basic valuation structure of residual income models remain unchanged, inflation distorts the linear dynamics such that even in a relatively low inflationary environment residual income models are likely to produce severe under valuations. We suggest appropriate modifications to overcome the problem of working with historic cost data in an inflationary environment.
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