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Residual income valuation models and inflation

Research output: Contribution to journalJournal article

Published

Journal publication date09/2011
JournalEuropean Accounting Review
Journal number3
Volume20
Number of pages25
Pages459-483
Early online date25/06/10
Original languageEnglish

Abstract

Existing empirical evidence suggests that residual income valuation models based on historical cost accounting considerably underestimate equity values. One possible explanation is the use of historical cost accounting under inflationary conditions. In this paper, we use a residual income framework to explore theoretically how historical cost accounting numbers need to be adjusted for inflation in forecasting and valuation. We demonstrate that even in a simple setting where inflation is running at a relatively low level, residual income models are likely to produce severe under-valuations if inflation is not properly taken into account. We use simulated data to reinforce our theoretical findings and to illustrate the difficulties that empirical investigators face working within the confines imposed by real data.