One-Year-Ahead Analysts’ Forecasts vs. the V/P Ratio: the Predictive Power of the Residual-Income-Based Valuation Model

This paper addresses the incremental effects of two anomalous variables: pricescaled one-year-ahead analysts’ early-in-the-year earnings forecasts from Elgers, Lo, and Pfeiffer (2001) and price-scaled implicit firm values from Frankel and Lee (1998), where implicit firm values are defined in a manner consistent with the Ohlson (1995) residual income model. Because analysts’ forecasts are input variables in the measure of implicit firm values, it is unclear whether the two anomalies capture the same underlying market mispricing. Moreover, Frankel and Lee (1998) suggest that the positive association between price-scaled implicit firm values and subsequent securities returns is due to the predictive ability of the residual income model. Such a conclusion may be premature, however, in light of the evidence that several of the constituent variables of implicit firm values have been found in earlier research to be associated with subsequent securities returns. Therefore, this paper investigates value-relevance of the residual income model with the appropriate control for the competing explanation. Overall, this paper finds that these two price-scaled anomalous variables are incrementally important. Specifically, one-year-ahead analysts’ forecasts are associated with subsequent securities returns only for short investment horizons and implicit firm values are price predictors only for long term.