Residual Income Valuation: Are Inflation Adjustments Necessary?

Byline: John O'Hanlon (1), Ken Peasnell (1) Keywords: equity valuation; residual income; inflation Abstract: This paper explores the question of whether the residual income valuation relationship (RIVR) should be written in inflation-adjusted terms. This question is of particular interest in the light of Ritter and Warr's (2002) claim that the standard nominal historical cost formulation of RIVR misvalues firms because it fails to deal properly with inflation. We present two inflation-adjusted formulations of RIVR, each of which is based on an income measure from the inflation accounting literature, and one of which is a general case of a formulation proposed by Ritter and Warr. We show that neither of these formulations is any more or less correct than the standard formulation of RIVR, and find no support for the view that it is necessary to write RIVR in inflation-adjusted terms. Finally we argue that, in a setting in which accounting numbers and forecasts thereof are normally presented in historical cost terms, the inflation adjustment of RIVR is likely to bring unnecessary complication to the valuation process, with increased scope for error. Author Affiliation: (1) Lancaster University Management School, Lancaster, LA1 4YX, U.K Article History: Registration Date: 04/09/2004 Article note: JEL Classification: M4