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ABSTRACT:
Residual income (RI) valuation is a method of estimating firm value based on expected future Accounting numbers. This study documents the necessity of using linear information models (LIMs) of the time series of accounting numbers in valuation. I find that recent studies that make ad hoc modifications to the LIMs contain internal inconsistencies and violate the no arbitrage assumption. I outline a method for modifying the LIMs while pre-serving internal consistency. I also find that when estimated as a time series, the LIMs of OhIson (1995), and Feltham and Ohlson (1995) provide value es-timates no better than book value alone. By comparing the implied price co-efficients to coefficients from a price level regression, I find that the models imply inefficient weightings on the accounting numbers. Furthermore, the me-dian conservatism parameter of Feltham and Ohlson (1995) is significantly negative, contrary to the model's prediction, for even the most conservative firms. To explain these failures, I estimate a LIM from a more carefully modeled accounting system that provides two parameters of conservatism (the income parameter and the book value parameter). However, this model also fails to capture the true stochastic relationship among accounting variables. More complex models tend to provide noisier estimates of firm value than more parsimonious models.

Key Words: Residual income, Valuation, Linear information dynamics, Con-servatism.
Data Availability: Data are available from sources indicated in the text.

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