The Role of Book Value in Equity Valuation: Does the Stock Variable Merely Proxy for Relevant Past Flows?

By Mohan Venkatachalam
1998| Working Paper No. 1491

We propose an alternative explanation for the value-relevance of book value. Specifically, we suggest that book value can have an indirect role in valuation even under an earnings capitalization framework. We first show that past earnings are relevant for valuation (in addition to current earnings) when earnings have transitory components. Next, we argue that book value may correlate with stock price simply because it aggregates past (and current) earnings. That is, the stock variable does not have a direct role in valuation; rather, its role arises indirectly because it proxies for relevant past flows. We test our hypothesis using a broad sample from a 30 year period 1967-96. Our findings are consistent with our predictions. We find that past earnings provide incremental explanatory power beyond that provided by current earnings. More important, we find that a model of current and past earnings outperforms a model of current earnings and book value in terms of explanatory power. Our results are striking when we split our sample into profit firms and loss firms. For profit firms we report that book value provides no incremental explanatory power beyond that provided by current and past earnings. However, for loss firms book value provides significant incremental explanatory power while current and past earnings provide only marginal explanatory power. This suggests a very restrictive direct role for book value in equity valuation, that is as a proxy for the firm’s abandonment or liquidation value.