When Capital Follows Profitability: Non-linear Residual Income Dynamics

Gary C. Biddle (), Peter Chen () and Guochang Zhang ()
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Gary C. Biddle: Hong Kong University of Science & Technology
Peter Chen: Hong Kong University of Science & Technology
Guochang Zhang: Hong Kong University of Science & Technology

Review of Accounting Studies, 2001, vol. 6, issue 2, No 6, 229-265

Abstract: Abstract Economic reasoning suggests that capital follows profitability. This study introduces into residual income valuation “capital follows profitability” investment dynamics whereby capital investments are guided by the profitability of underlying investment opportunities. These investment dynamics predict convex versus linear relations between future and current residual income, with slope and convexity dependent on investment opportunity. We test these predictions against the linear information dynamics (LID) proposed by Ohlson (1995) and Feltham and Ohlson (1996), with supportive results. These findings point the way to further development of links between firm value and the economics of value creation.

Keywords: residual income; valuation; linear information dynamics; investment dynamics; non-linear residual income dynamics (search for similar items in EconPapers)
Date: 2001
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DOI: 10.1023/A:1011666926073

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