Opportunities Knocking: Residual Income Valuation of an Adaptive Firm

Abstract

Maintaining a competitive edge requires a firm to replace deteriorating business lines with new projects. Accordingly, part of a firm's value resides in its ability to exploit new opportunities. This article incorporates adaptation into Ohlson's residual income valuation framework and obtains a non-linear (convex) valuation formula. Although parsimoniously cast, the model makes two predictions which are consistent with phenomena reported in the empirical literature: earnings convexity and complementarity. Moreover, the Appendix introduces a new and powerful Equivalence Theorem. This Equivalence Theorem relates Modigliani-Miller dividend invariance to complementarity and earnings convexity in accounting-based valuation. For Web-based Abstract, see: http://papers.ssrn.com/paper.taf?abstract_id=239368