The Residual Income Model And Its Application In China

Equity Valuation is a major theoretical issue. Global stock markets'rapid development and expansion intensified the asset bubble. The explanation and research for the bubble is an urgent task. Equity valuation is the beginning and major component of stock's bubble research. After accurately measuring the equity value, bubble research could be implemented.Equity valuation is the stock market's micro-foundation, which could reduce the stock market's fluctuations and the financial risk. The economic managers may execute appropriate policy to screed the stock market's fluctuations after measuring the stock's value correctly. Otherwise, the managers would execute the inappropriate policy, and which would intensify the stock market's fluctuation, strengthen the financial risk, and lead to a financial crisis and an economic recession. Equity valuation is the investor's key to open the door of success. Greed and fear is the natural enemy of the stock market investment. Institutional investors'herding, individual investors'buying rising and selling falling is the most direct embodiment of greed and fear. The best way to overcome greed and fear is to calculate the value of the stock, persist on value investment, and sell when the market price is higher than the value of the stock, buy at prices below market value. Equity valuation is the first step to successful investment, is also the most crucial step.There are two traditional equity valuation methods, dividend discount model and cash flow discount model. They have three fatal flaws. First, they use the future data, which need the forecast. In conditions of uncertainty, we can not accurately estimate the future operation of the enterprise, usually a wide valuation error. Secondly, there are sum formula for endless peace in the two valuation models, which lead us can't directly testing the model by econometrics, meanwhile, would form truncation error. Thirdly, the two models fail to make full use of accounting data and enough information. Modern Accounting Information View found that the net assets per share, accounting surplus and count items contain a wealth of useful information. How do we have these accounting data to integrate equity valuation?Ohlson, accountant scientist, had the residual income model, and overcame the defects of dividend discount model and cash flow model. Residual income refers to the difference accounting earning and normal cost of capital. Residual Income = Earnings-the cost of capital. Residual income model refers to measuring the equity value by adding up the net assets and residual income. Ohlson thought that residual income was mean return, and enterprise couldn't make excess profit for ever because of the market competition. Ohlson had the idea into the hypothesis of linear information dynamic, and the residual income is the sum of its lag items and non-accounting information variable. Through mathematical transform, stock values could be expressed as a sum of accounting net assets, the remaining residual income and non-accounting information variable v. The dissertation tested the Ohlson's linear information dynamics and residual income model by our national data. We tested the five remaining proceeds of linear information dynamics, and studied the cost of capital's effect to linear information dynamics. We compared the explaining ability of five residual income models and the difference of between residual income model and earning capitalization model, cash flow model, and compared the difference of residual income model and the rate of price-earning, price-book value and price-sale.Our empirical results showed that the residual income was affected by the book value's lag items except for its lag items and that our accounting policies are stable as to Ohlson's hypothesis. And our data didn't support the assumption that residual income proceeds AR2 process. It, AR2 items'regression coefficient, is statistically insignificant. Our analysis showed that the cost of capital has a great impact on the residual income model. So we must consider the cost of capital's difference when we test the linear information dynamics.We found that the residual income model derived from linear information dynamics including net assets exceed the residual income model derived from linear information dynamics including no net assets on the explaining stock price's ability. And the error is great, the explaining ability is poor when we get the residual income model through the residual income's AR2 process. Meanwhile, we found that the residual income model exceed the earning capitalization model and cash flow model on the explaining ability to stock price, and the error would reduce when we lengthen the duration of cash flow growth.Our data results showed that the distinction ability and stability of residual income model was far higher than earnings capitalization model and cash flow model. The predicting stability would be vulnerable to extreme values for the rate of price- earning, price-book value and price-sale comparative to residual income model. In industry, the rate of price-earning looked more like a reverse indicator, the income was low when the nowadays average price-earnings ratio was high and the income was high when nowadays low. The rate of price-sale quantity could find out the extremist outstanding and poor company, but the rate was not stable and useful, so it was not appropriate that using the rate lonely. The rate of price-book vale could forecast the future income stably, but the distinction was low, we could get less arbitrage through the price-book rate than through the residual income model.