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An earnings-based valuation model in the presence of sustained competitive advantage

Research output: Working paper

Published
Publication date1996
Place of PublicationLancaster University
PublisherThe Department of Accounting and Finance
Original languageEnglish

Publication series

NameAccounting and Finance Working Paper Series

Abstract

In this paper, the process which generates a company s economic value and its accounting numbers is represented in terms of the company s investment in, and utilisation of, competitive advantage. Within this representation, it is shown that a company which earns normal economic returns might plausibly generate perpetual exponential growth in positive net present value projects, in unrecorded goodwill and in residual income. Since exponential growth in residual income may make it impracticable to construct earnings-based valuation models which employ the time-series properties of unscaled residual income (or of unscaled earnings), it is argued that earnings-based valuation models should employ the time-series properties of scaled residual income (or of scaled earnings). A model which incorporates such properties is then derived. In a certainty setting in which there are no shocks to the economic return series, economic value is a function of normal profitability and of normal book value growth; in a setting in which shocks to the economic return series occur, it is necessary to add a term which reflects transitory abnormal profitability and a term which reflects transitory abnormal book value growth. The importance of the abnormal profitability term is determined by persistence in abnormal profitability; the importance of the abnormal book value growth term is determined by the normal market-to-book ratio.