Accruals, Accounting-Based Valuation Models, and the Prediction of Equity Values

Abstract

This study uses out-of-sample equity value estimates to determine whether earnings disaggregation, imposing linear information valuation model (LIM) structure and separate industry estimation of valuation model parameters aid in predicting contemporaneous equity values. We consider three levels of earnings disaggregation: aggregate earnings, cashflow and total accruals and cash flow and four major components of accruals. For pooled estimations, imposing the LIM structure results in significantly smaller prediction errors; for by-industry estimations, it does not. However, by-industry prediction errors are substantially smaller, suggesting that the by-industry estimations are better specified. Mean squared and absolute prediction errors are smallest when earnings are disaggregated into cash flow and major accrual components; median prediction errors are smallest when earnings are disaggregated into cash flow and total accruals. These findings suggest that (1) if concern is with errors in the tails of the equity value prediction error distribution, then earnings should be disaggregated into cash flow and the major accrual components; otherwise earnings should be disaggregated only into cash flow and total accruals; (2) imposing the LIM structure neither increases nor decreases prediction errors, which supports the efficacy of drawing inferences from valuation equations based on residual income models that do not impose the structure implied by the model; (3) valuation of abnormal earnings, accruals, accrual components, equity book value, and other information varies significantly across industries.