| Capital market theory developed in the past quarter century suggests that risk is an important factor in the setting of market prices. As risk grows, a firm's value declines so that risk averse investors are rewarded for taking on additional risk with a greater return on their investment. This study uses the residual income valuation model to demonstrate empirically that as the riskiness of a firm's earnings increases, its market value declines.; The residual income model (RIM) has been used by accounting researchers in the past decade to study firm value because it is consistent with well accepted theories in finance and its primary inputs are familiar accounting measures. RIM shows that firm value is equal to the present value of a firm's expected future residual income flow. Empirical implementations of RIM typically express stock price as a function of book value, earnings, and/or earnings forecasts. To incorporate risk, many prior studies have relied on discount rate adjustments in the present value portion of the model.; This study adds to the literature by more rigorously incorporating earnings risk into the residual income model. The risk adjusted residual income model proposed includes several indicators of earnings risk: the variability in analyst forecasts, short term refinancing exposure, geographical diversification, operational diversification, operating leverage, and size. The results confirm that earnings risk is an important component of the market valuation process.; Using a sample of more than twenty thousand firm-years over the 1983 to 2001 time period, my empirical analysis finds that the additional earnings risk measures significantly improve RIM's ability to explain market prices. In addition, the evidence shows that each risk measure conveys meaningful information about the pricing process. The variability of earnings expectations, exposure to interest rate fluctuations, geographical diversification, operating leverage, and size all significantly affect stock prices. The evidence suggest that while operational diversification does not have an overall impact on firm value, it does significantly affect how the market individually prices earnings and earnings forecasts. This study can help our quest to better understand how earnings and earnings risk factors create value in the eyes of investors. |
