Momentum, Acceleration and Non-Linearities in Equity Valuation on the Shanghai Stock Exchange

The standard empirical paradigm for assessing the relationship between the market value of a firm’s equity and the accounting information appearing in the firm’s financial statements, is based on the assumption that the firm is indefinitely constrained to operate within its existing investment opportunity set. Based on this assumption, the Ohlson (1995) model, which is developed by characterising a firm’s investment opportunity set in terms of a first order vector system of stochastic differential equations, shows that the market value of a firm’s equity will be a linear combination of its current abnormal earnings, the current value of an “information” variable and the current book value of its equity. However, the pre-existing empirical evidence shows that the Ohlson (1995) model does not provide a satisfactory description of the relationship between the market value of a firm’s equity and the information appearing in its published financial statements. Recent developments in equity valuation theory also show that the higher order derivatives of the accounting variables comprising a firm’s investment opportunity set - that is, the momentum and acceleration of the accounting information disclosed in a firm’s financial statements - can potentially make a significant contribution to the overall market value of equity. This in turn will mean that a firm’s investment opportunity set ought to be characterised in terms of a second or third order system of stochastic differential equations. Omitting the momentum and acceleration of the accounting variables from the equity valuation process could lead to the under-estimation of equity values. Moreover, recent empirical evidence also shows that the market value of a firm’s equity is potentially, a complex non-linear function of a firm’s accounting information appearing in financial statements. The non-linear effects arise out of the adaptation (real) options associated with a firm’s ability to modify or even abandon its existing investment opportunity set. However, empirical work on the relationship between the market value of equity and the accounting information appearing in financial statements continues to be based on linear models which do not take account of either the momentum and acceleration in a firm’s accounting variables or the non-linear effects associated with the real options available to the firm. Given this, it is all but inevitable that when these valuation effects are ignored, systematic biases will arise in empirical work dealing with the determinants of equity values. Moreover, empirical work in this area has been almost exclusively based on North American and European data. There is, in particular, a dearth of empirical work in developing countries like the People’s Republic of China. This dissertation refines the equity valuation models summarised in the literature by incorporating momentum, acceleration and non-linear equity valuation effects and then empirically tests them against data obtained from the Shanghai Stock Exchange (SSE). The empirical analysis summarised in this dissertation shows that neither earnings momentum nor earnings acceleration exhibit a significant impact on the market value of equity for the pooled sample data on which the empirical analysis is based. However, when the pooled sample data are divided into three equally numerous groups based on each firm’s operational efficiency, earnings momentum for firms with moderate operational efficiency exhibits a significant association with the market value of equity. This contrasts with the low-efficiency and high-efficiency sub-sample firms, where earnings momentum appears to have an imperceptible effect on equity prices. However, whilst it is shown that earnings momentum can have an impact on equity prices of moderate-efficiency firms, its effect is minimal in explanatory terms and adds very little to parsimonious regression models based on earnings and book value alone. Earnings acceleration does not appear to impact on equity values - neither for the pooled sample data nor for any of the three efficiency sub-samples. The empirical analysis summarised in this dissertation also shows that there is a strong non-linear relationship between the market value of equity and the accounting information appearing in published financial reports for firms listed on the SSE. In particular, for low-efficiency firms liquidation option value appears to make a significant contribution to the overall market value of equity. For high-efficiency firms growth option value appears to make a significant contribution to the overall market value of equity. For firms with moderate operational efficiency real option value is negligible and thus for these firms the relationship between the market value of equity and the accounting variables on which the empirical analysis is based is approximately linear.