Abstract

In this paper, some factors are examined which are associated with equity value in an immature and emerging market, China. In the developed countries, research has indicated that both earnings and book value are playing an important role in forecasting equity value. While in China, earnings seems to have information content but earnings, by itself, seems to be weakening in importance over time. Book value has a more significant association with equity values. In the risky and unstable environment of China, where future expected earnings is quite uncertain, investors may not be pay much attention to earnings, but be more concerned for the book value. Regarding the role of book value, there are competing explanations.

While some researchers conclude that book value was only important because of its contribution as a control for scale differences (Barth and Kallapur, 1996), others conclude that the important role book value played because it was a useful proxy for expected future normal earnings (Ohlson, 1995). Still others conclude that it is only relevant in the valuation of loss making and unsuccessful companies generally (Berger, Ofek and Swary 1996; Burgstahler and Dichev, 1997). The result of this paper indicates that, overall, earnings and book values are two important determents for pricing stock in China. Furthermore, this study indicates that book value is also important in an unstable economic environment and immature stock market, like China, which is still in early stage of capital market.

1 Introduction

1.1 Brief history

In the mature market, empirical research finds that earnings and book value can be used to predict firm value. In particular, researchers have examined the association between earnings, book value, and a combination of both with stock prices and have found it to be significant (Ball and Brown 1968; Ball 1972; Kaplan and Roll, 1972; Collins and Kothari 1989; Burgstahler and Dichev, 1997).

In an important paper referred as a landmark work, Ohlson (1995), in a famous paper, modeled this association and provided a widely used framework for empirical exploration. Burgstahler and Dichev (1997), a significant study in this area, indicated that equity value is an option style combination of recursion value and adaptation value. Recursion value (see Burgstahler and Dichev, 1997) is capitalized expected earnings when the firm recursively applies its current business technology to its resources. Adaptation value means the value of the firm’s resources adapted to alternative use. Current earnings are used as a proxy for recursion value and book value of equity is used as a proxy for adaptation value.

While earnings provide a measure of how the firm’s resources are used currently, book value provides a measure of the value of the firm’s resources independent of how the resources are used currently. They note that, in particular, when the ratio of earnings to book value is high, earnings is the more important factor than book value of equity value. This is because under such a condition the firm is more likely to continue using resources in its current way. In contrary, when the ratio of earnings to book value is low, book value becomes the more important factor than earnings in equity valuation. Under this alternative condition, the firm is more likely to exercise the option to adapt its resources to a better alternative use.

1.2 Objectives

In this dissertation, I will focus on the association between earnings and book value with stock prices in the Chinese stock market. Analysis of the Chinese market presents the potential for obtaining insights into stock pricing in an emerging or immature market. While some arguments could be made that certain aspects, for example, political and economic consequences of joining the World Trade Organization (WTO), make the Chinese market unique.

In general, however, it should be noted that the Chinese market is still very reflective of developing (emerging) markets. Los and Yu (2008) classify China as an emerging market because of its low per capita income, chronic inflation, thin and immature capital markets, and concentrated financial and industrial sectors; criteria that they use to characterize emerging markets generally.

Although the two Chinese Stock Exchange, the Shanghai Stock Exchange (SHSE) and the Shenzhen Stock Exchange (SZSE), were founded in December, 1990. The Chinese stock market is considered one of the highest growing emerging markets. But it is still small relative to the stock markets in developed countries. As Han et al. (2006) note, potential inefficiency and volatility also characterize the Chinese market. In the market, the buying and selling activity of a few large investors can make great effect to the stock prices.

China is experiencing a highly economic transition and on the path to become an important and irreplaceable part of economic integration all over the world at present. Therefore, it is interesting to examine if the association of earnings, book value with stock prices which is applied to the larger and more efficient market will still hold in an immature (developing) stock market, like China. The objective of this dissertation is to examine the relationships between recursion value (earnings), adaptation value (book value) and equity value in an emerging stock market.

The results of this dissertation will show that earnings is associated with stock price significantly for successful and middle-of-the-road companies; while, book value is associated with stock price significantly for unsuccessful companies. This may indicate that the “recursion value” portion of a company’s equity value is relatively of greater importance in equity valuation than “adaptation value” for successful (high earnings) companies, whereas the “adaptation value” portion of a company’s equity value is relatively of greater importance in equity valuation than “recursion value” for unsuccessful (low earnings) companies.

1.3 Economic and stock market characteristics of China

This dissertation will examine the potential factors that cause the variation of stock prices in different conditions. Therefore, it is imperative to understand the economic and institutional influence behind such differences and the characteristics of Chinese stock market.

In this section, I summarize the history of the Chinese stock market. China’s economy has changed from a centrally-planned economy (CPE), which was introduced in 1949, to a more market orientated economy since 1978. China’s economic transition has been accompanied by a great social achievement since the late 1970s. However, there were some inherent deficiencies of the CPE, like the defective functioning of the planning mechanism, the monopolistic, non-contestable position of the State-Owned Enterprises (SOEs), the lack of adequate incentives, the lack of financial sanctions, the macro-economic, suboptimal allocation of resources (Gao, 2006 ).

During the last three decades, China’s great successful economic transition has been accompanied by huge and complex social change, with an officially reported GDP growth rate of 9.5 percent per year since 1980 (Lindbeck, 2008). The growth rate of China’s economic has been among the highest in the world, especially since 1990.

And China is a significant participant in the global economy currently. One of the most important developments was the reactivation of the stock market. To strengthen the operating performance and release the capital shortage experienced by SOEs, China has been promoting a market economy through corporatizing (i.e. privatizing) SOEs and developing securities markets.

The origin of stock market in post-1949 mainland China can be traced to July 1984, when Beijing Tianqiao Department store was converted into a shareholding company. In August 1984, the Shanghai municipal government approved the first principle-level regulation on securities. The first stock was subsequently issued by a household electronics company in November 1984 and traded in August 1986 on the OTC market. In the next few years, more SOEs were “incorporated” by the selling of shares to their employees, other stock companies and other SOEs. The stock market, however, didn’t become a significant vehicle for SOE reform until the establishment of the two stock exchanges. In the early 1990s, the SHSE and the SZSE established, in December 1990 and in July 1991 respectively. In the following year, the Chinese Security Regulatory Commission (CSRC) was set up, as the Chinese equivalent of Securities and the Exchange Commission in the United States, to monitor and regulate the stock market. Since then, the stock market has grown in a high speed, expanded rapidly and facilitated the reform of SOEs (Haw et al, 1999).

In 1991, there were only 13 stocks listed and traded on these two exchanges (eight on SHSE and five on SZSE). By the first quarter of 2009, the number of firms listed had increased to 1625 (864 on SHSE and 761 on SZSE). (Gao, 2009) The total market capitalization of listed firms increased about 1522-fold over the 18-year period, from 11billion reminbi in 1991 (equivalent to about US$1.3 billion) to 12056.6 billion renminbi (equivalent to about US$1773 billion) in 2008 (Table 1). As of 24 April 2009, the total market capitalization was valued as 16742.768 billion renminbi (equivalent to about US$ 2462 billion) (Haw et al., 1999).

Table 1

Number of Listed Firms and Market Capitalization in Chinese Stock Exchange – 1991- 2008

Source: The Shanghai Stock Exchange (SHSE), Shanghai, China

Note: The SOEs listed in this in these two domestic exchanges were originally authorized to issue common shares only to Chinese citizens, which is called “A-shares”. Since 1992, some of the selected A-shares companies have been allowed to foreign investors, which are called B-shares. Only less than 1 percent of the total market value was financed through the selling of B-shares. Thus, the A-shares are the primary source for equity financing for listed Chinese firms.

2 Literature review

In this section, I initially discuss studies that examine the relationship between equity value and earnings and the relationship between equity values and book values respectively; then I examine the association of earnings and book values with equity values; finally I will focus on studies that have examined data from the Chinese stock market.

2.1 Studies examining association of earnings with equity value

Generally speaking, much of the research in this area for the last 30 years was focused on inspecting the relationship between certain variables and equity values or stock price. In a seminal study, Ball and Brown (1968) found a positive and statistically significant association between earnings and equity value. An empirical evaluation of accounting income figures required for agreement as to what real-world results constituted a useful appropriate test.

Because net income was a figure of particular interest to investors, the result they used as the standard forecast was the investment decision making as it was reflected in security prices. Since usefulness could be reduced by deficiencies in either of the content or the timing of existing annual net income numbers, both of them would be evaluated.

The developments of capital theory at that time provided more choices to the price of security as an operational test of the usefulness of business. Impressive Institutions to support the idea of the theory that the capital market are both effective and fair, if the information is useful in forming capital asset prices, then the market in asset prices will be quickly adjusted to the information without leaving any opportunity for further abnormal gain.

As the evidence indicates, if stock price do in fact really quickly adapt to the new information and then changes in stock prices will reflect the information market. As observed revision of stock prices and income report published would provide the evidence that the information reflected in the income figures are useful. Ball and Brown’s method of accounting on income to stock price was based on the theory and evidence by focusing on the unique information which is to a specific company. Specifically, Ball and Brown built two alternative models of what was the market expected income to be, and then investigated the error when the expected market response.

2.1.1 Expected and unexpected income changes

According to Ball and Brown (1968), the income of enterprises in America tends to move together over the time. It has been demonstrated that about half of change in the level of average earnings per share (EPS) of a firm could be influenced by the whole economic environment. At least part of the change in the company’s income from one year to the next could be expected. In the past years, if a company’s revenue had been associated with other companies in a particular way, then understanding that relationship of the past, together with the understanding of the income of those other companies, had a particular expected rate of return at present.

Therefore, in addition to confirm the impact of new information can have a similar equivalent to the differences between real change in income and expectations of income. But not all of these differences must be new information. A number of changes in income were due to financing and other policy decisions made by the firm. Ball and Brown assumed that, to a first approximation, these changes were reflected in average change in income through time. Since the influence of the two components of change were felt at the same time, that is, economy wide and policy effects, the relationship must be estimated jointly.

2.1.2 The market reaction

It had also been demonstrated that stock prices move together with the rate of return from holding stocks. The whole market return was influenced by the information released by all enterprises. (Ball and Brown, 1968) Since they were assessing report of income as it related to each company, its content and timing should be evaluated relative to the changes in the rate of return on the firms stocks net of whole market effects.

2.1.3 Some economic issues

An assumption for Ordinary Least Squares (OLS) income regression model was that the average income of firm j in the market (Mj) and the unexpected income change were uncorrelated. Correlation between them could take at least two forms, which contained the firm in the market index of income (Mj) and the industry effects at that time. The first had been eliminated by construction (denoted by the y-subscript on M), but it had not been adjusted due to the impact of the industry at that time. It had been estimated that the impact of industry might account for only 10 percent of the variability of the income in a company.

For this reason the model had been adopted as appropriate specifications, to believe that any bias in the estimates would not be very significant. However, as the statistical efficiency inspection on the model, Ball and Brown also presented results for another naïve model, which predicted that the income would be the same as last year. The forecast error (i.e. unexpected income change) was only changes in income since the previous year.

As was the case with the income regression model, stock returns model contained a number of apparent violations of OLS assumptions. The return of market index was relevant to the residual because the market index contained the return for firm j, and because the industry impacts. Neither violation was serious, because the “Combination Investment Performance Index” of Fisher (Fisher, 1966) was calculated over all stocks listed on the New York Stock Exchange (hence stock returns was only a small portion of the index), and also because the industry impacts accounted for up to 10 percent (Brealey, 1968) of the changes in the rate of return on the average stock. Again, any bias had little effect on the results, because there is in no case was the stock return regression that was fitted over 100 observations (Fama, et al., 1967).

Therefore, Ball and Brown (1968) assumed that it was impossible that no useful information about a particular firm reflected the rate of return during a period, but only the market-wide information that fitted for all firms. By abstracting market impacts, they identified the impact of information fitted to individual firms. Then, in order to determine whether part of the effect could be associated with information contained in the numbers of accounting income of a firm, they separated the expected and unexpected changes in income.

If the income forecast error was negative, that was, if the actual change in income was less than its conditional expectation, they defined it as a bad news and predicted that if there was some relationship between accounting income numbers and stock prices, and then releases of the income figures would lead to the return on that firm’s stock, which was less than what would have been originally expected.

The results from the empirical test of Ball and Brown showed that the information contained in the annual income figures were useful, as it related to stock prices. Beaver, Clark, and Wright (1979) found similar results and confirmed the initial findings of Ball and Brown (1968). Subsequent studies (Barth, Beaver, &Landsman, 1992; Collins & Kothari, 1989) found similar results again. The research of Lipe (1990) found that the relationship between earnings and equity value changes with the persistence of earnings.

This study found that the equity value during a period is a function of (1) the time-series persistence of the earnings series, (2) the interest rate used in discounting expected future earnings, and (3) the relative ability of earnings versus alternative information to predict future earnings. The comparative statistics of Lipe (1990) showed that the response coefficient played an increasingly important role for past earnings to predict future earnings and an increasing function of persistence. In addition, the movements of stock price changed conditionally on earnings being announced was a decreasing effect of the predictability of the earnings series and an increasing effect of earnings persistence. If the predictability or response-coefficient effect was positive, that was because the value attached to a one-dollar current-period earnings shock was an increasing effect of predictability; if the predictability or variance-of-price-changes effect was negative, that was because the average quantity of unexpected information released during the period was a decreasing effect of predictability. Other studies refined the earlier studies by disintegrating earnings into components and then empirically testing the association between these components and equity values (Lipe, 1986; Wilson, 1986).

2.2 Studies examining association of book values with equity values

A great number of studies focus on the balance sheet measures of assets and liabilities. These studies find a statistically significant relationship between book values and equity values of the firm (Penman, 1992; Barth & Kallapur, 1996; Ohison, 1995; Berger, Ofek, Swary, 1996; Burgstahler & Dichev, 1997). Book values of the firm’s assets and liabilities are used in these studies, which reinforce the assumption that measures of assets and liabilities reflect the expected results of future activities.

However, some different conclusions are arrived at by the studies regarding the importance of book value. Barth and Kallapur (1996) stated that book value was important only because it acted as a control for size differences. Penman (1992) and Ohlson (1995) concluded that book value is important because it also acted as a proxy for earnings. Still others offer a competing explanation.

Berger et al. (1996) reported that there is a positive and highly significant relation between market value and estimated liquidation value after controlling for present value of expected cash flow. Further assurance that correlated omitted variables do not affect the results is provided by the fact that the positive relation between market values and liquidation value changes in holding as well as levels.

Berger et al. (1996) stated that the abandonment option was equal to an American put option on a paying dividend stock. Their analysis of this option results in the forecasting about how liquidation value influences firm value. All the other equality, the abandonment option leads to firms with a much bigger number of liquidation values being worth more investors. Therefore, they predict that market value is positively associated with liquidation value, after controlling for the relationship between market value and the present value of expected cash flow.

Generally speaking, liquidation value for going concerns is not observable. Moreover, they concern more about the association between balance sheet information and the abandonment option’s value. They, therefore, estimate the relation between book value and liquidation value for major asset classes by choosing and analyzing the discontinued options footnotes of 157 sufficiently-detailed information firms. They find that one-dollar book value produces, 72 cents of liquidation value for receivables on average.

Applying these estimates to the balance sheet disclosures of all the firms used as samples provides them with estimated liquidation values. In the empirical results, they report that after controlling for the option’s exercise price, the market value of a firm’s equity increases in a close approximation one for one with increases in the present value of after-interest cash flows. The significant positive estimate on the excess liquidation value movements continues to support the inference that the abandonment option makes a more important and significant contribution to the market value of a firm’s equity than that made by the present value of cash flow.

To investigate the change over time in the association between abandonment option value and liquidation value, and to solve that problem that the pooled observations may not be independent, because it includes the same firm for many years. The results of their further research continue to show a positive, strong relation between the estimated liquidation value and the market value of the firm’s equity. Moreover, to further reduction of the concern that the inferences may be influenced by the liquidation value measure capturing a portion of true present value of cash flow that is omitted from their proxy, they perform an analysis in changes.

At the same time, the sample contains all first differences of the firms from the levels analysis that meet sample selection restrictions. Berger et al. (1996) require that the first earnings prediction occur no later than the fourth month after the date liquidation value is calculated, which make sure that the changes in liquidation value and present value of cash flow are aligned properly in time for each firm in the sample. The change of percentage in equity value is for the purpose that captures the impact of operational decisions, not the impact of insurances and redemptions. So they delete the firms with insurances and retirements.

The results for the changes is as expected, the fact that the latter estimate is significantly positive supports strong evidence, however, that the association they documented earlier between equity value and liquidation value was not affected by liquidation value and the present value of cash flow that both measure different part of true present value of cash flow. The constant component of any association between liquidation value and the omitted part of true present value of cash flow is removed by examining changes rather than levels. Therefore, Berger et al. continue to find the strong, positive association liquidation value and equity value of a firm.

Berger et al. (1996) and Burgstahler and Dichev (1997) concluded that book value has relatively more significant association with stock prices when a firm is unsuccessful and making losses. They argued that this was because book value acted as a proxy for the “abandonment option”.

2.3 Studies examining association of earnings and book values with equity values

Some studies observe the association between earnings and book values with equity values. Bernard (1995) tested several valuation models empirically. He found that book value per share accounted for 55% of the cross sectional variability in price per share; that book value and rank of return on equity accounted for 64% of the variation in equity price; and that estimated earnings and book values accounted for 68% of the variation in equity prices.

Ohlson (1995) did not focus on earnings alone; theoretically, he modeled the role of earnings, book value and dividends in the valuation of a firm’s equity. An important combined function to the statement of changes in owner’s equity is allocated by accounting method. The statement includes the bottom-line items in the balance sheet and income statement, book value and earnings, and its format needs the change in book value to equal earnings minus dividends.

This relation is referred as the clean surplus relationship because all changes in assets and liabilities which are unrelated to dividends must pass though the income statement. Generally, this scheme is accepted by accounting theory without connecting it to a user’s perspective on accounting data. While the underlying idea that net stocks of value settle with the creation and distribution of value produces a basic question in an equity valuation context: whether one can create a cohesive theory of a firm’s value that depends on the clean surplus relation to identify a distinct role for each of the three variables: earnings, book value and dividends. Ohlson (1995) resolves the question in a neoclassical framework.

In this case, the analysis starts from the assumption that value is equal to the present value of expected dividends (Rubinstein, 1976). Then one can assume the clean surplus relation to replace dividends with earnings and book values in the formula of present value. At the same time, a multiple-date, uncertain model such that earnings and book value act as complementary value indicators is led to by assumption on the stochastic behavior of the accounting data, In a specific way, the main point of the valuation function expresses value as a weighted average of (i) capitalized earnings at present (adjusted for dividends) and (ii) book value at present. Extreme parameterizations of the model produce either capitalized earnings or book value at presents the only value indicators.

Ohlson (1991) have examined both of the settings. At its most primary level, he accordingly generalizes prior analysis to derive a convex combination of a pure flow model of value and a pure stock model of value. The combination is an interesting conception because both the bottom-line items are brought into valuation through the clean additional relation. The development of model, in which Ohlson (1995) produces the value of a firm as linear additive functions of both earnings and book value, shows the relevance of abnormal or residual earnings as a variable that drives a company’s value.

Earnings minus a charge for the use of capital define this accounting-based performance measure as measured by book value that is in the beginning of period multiplied by the cost of capital. Abnormal or residual earnings hold on the difference market and book values, that is to say, they bear the goodwill of a company. As a matter of fact, a particular parsimonious expression for goodwill is derived from a straight forward two step procedure as it relates to abnormal or residual earnings.

Firstly, following Peasnell (1981) and others, the clean surplus relation indicates that goodwill is equal to the present value of future expected abnormal or residual earnings. Secondly, if one further assumes that abnormal or residual earnings comply with an autoregressive process, then it follows that goodwill is equal to abnormal or residual earnings at present scaled by a positive constant. The results emphasize that value can be driven by assuming abnormal or residual earnings processes that make no reference to past or future expected dividends.

Not only does owners’ equity accounting subsume the clean surplus relation, it also indicates that dividends reduce book value but leave earnings at present unaffected. This additional feature is exploited to examine the margin effects of dividends on value and on the evolution of accounting data (Modigliani, 1958; Miller, 1961). Market value is displaced by dividends on a dollar for dollar basis, so that dividend payment irrelevancy applies. In addition to that, dividends that paid today impact expected future earnings negatively.

The creation of wealth is separated by the model accordingly from the distribution of wealth. On the important condition that one generally attaches to Modigliani and Miller (1958, 1961) properties in valuation analysis, the economic significance of owners’ equity accounting is enhanced by the requirement that dividends reduce book value but not current earnings. The model allows information beyond earnings, book value and dividends. The additional information is motivated by the idea that expected future earnings are affected by some relevant value events as opposed to current earnings, that is to say, accounting measurements incorporate some relevant value events only after a time delay. The feature is interesting because the analysis implies that the weighted average of capitalized earnings and book value still support the main point of the valuation function, though the accounting data will be incomplete indicators of value.

Ohlson (1995) made a conclusion that, earnings at present might have a strong relation with market value of equity while current dividends are more important than future earnings in predictive ability. He made the theoretical framework for further empirical explorations.

In a further refinement of Ohlson (1995), Burgstahler and Dichev (1997) showed that earnings and book values are positively and significant associated with equity values. However, they found that the relationship was nonlinear (i.e., moderated by factors such as success of a firm) and not additive as suggested by Ohlson (1995). In 1997, the research of theirs developed an option- style model of equity value that incorporated the capitalized value of the firm’s expected earnings (under the assumption that the firm continues its current way of employing resources) but also explicitly recognized the value of firms adaption option (i.e. the value of the option converted the firm’s resources to alternative, more productive uses).

The main forecasting of the model is that the value of equity is a convex function of both expected earnings and book value. Their empirical evidence strongly supported the prediction of convexity – the coefficient on earnings increased with the ratio of earnings to book value and the coefficient on book value decreased with the ratio of earnings to book value. They developed two propositions for the relationship of recursion (a proxy of earnings) and adaptation value (a proxy of book value of equity) components with market value.

In the model below, an option-style combination of recursion value and adaptation value are reflected in the equity value. Recursion value is capitalized expected earnings when the company recursively applies its business technology at present to its resources. Adaptation value is the value of the company’s resources which adapted to an alternative use.

The possibility that the company will exercise the option to conform the resources to another way to use is reflected in the relative weights on the two factors of market value of equity. In a specific way, when the recursion value is not high relative to the adaptation value, the company will opt out of recursion value in favor of adaptation value. Two propositions are led to by the shape of valuation function in each argument. The model is as follows:

MV (E, AV)EAV

There are four basic terms in the model. MV represents market value of equity; E represents expected future earnings which use the company’s business technology at present; c represents capitalization factor for earnings; AV represents adaptation value.

E and AV are random variables. The joint distribution of the two variables is described by the multivariate normal density which is parameterized by a vector of means and variance-covariance matrix, f(E,AV) = f({E,AV},{E,AV,E,AV}). All information available that are relative to the evaluation of future expected earnings and adaptation value is assumed to be captured by the parameters of the multivariate distribution. The covariance between E and AV will be positive generally, that is to say, companies with higher levels of earnings typically employ more resources (AV), and companies with more resources typically yield higher levels of earnings.

The recursion value factor of market value of equity is the discounted value of future expected earnings. The recursion value is supposed to be the result of expected future earnings E and an earnings capitalization factor c. The capitalization factor c implicitly indicates risk-adjustment, the arrangement of future interest rates, and other features which are sometimes included in valuation models.

The option as reflected by the equity value is to choose either the recursion value or the adaptation value, whichever is larger, at some point in the future. The deviation assumes that at only one point in time adaptation value can be exercised. Therefore, it follows that the value derived is a conservative estimate of the value which would result if investors have more opportunities to exercise the adaptation option, as investors cannot be worse off when they have more frequent opportunities to exercise.

What else should be noted is that investors are assumed risk-neutral, so that expected wealth maximization is enough to characterize their preference. The model above supports the structure to examine the association of earnings and book value with equity value.

1. Market value as a function of earnings for fixed book value

The model above is used to examine the value-relevance of recursion value which means capitalized earnings, on the condition that h book value is constant. The conditional density function are denoted for E by f(E,AV), and expanding model above for a fixed AV, and equity value is given by:

MV (E, AV) =+

Source: Burgstahler and Dichev (1997)

The limit of integration, AV/c, is the point of investors indifference where recursion value, that is, capitalized earning, equals adaptation value. For E>AV/c, investors prefer to continue to operate the company using the business technology at present, while for E<AV/c, investors prefer to adapt resources to an alternative use.

If rearranging the equation, it yields:

MV (E, AV) =AV +

Source: Burgstahler and Dichev (1997)

In this case, the equity value on a condition that the book value is constant can be explained as the sum of the adaptation value plus the value of an option on the recursion value. In a specific way, the integral term in this equation is a call option effectively, whose value is rising in the conditional way of expected future earnings.

The proposition below describes a testable implication of the conditional valuation function:

Proposition 1: On a condition of a given adaptation value, market value is an increasing, convex function of expected earnings.

In an intuitive sense, it follows because as the conditional mean of earnings increases in future, the value of the call option on earnings increases. In addition to that, the revision in market value is because a given improvement in expected future earnings is increasing in the level of expected earnings.

Figure 1 shows that market value of equity is a result of expected earnings for a fixed adaptation value. The horizontal line in the figure below means a fixed adaptation value, the upward sloping line means recursion value, which is increasing and linear in the level of expected earnings. The two lines cross at a point E = AV / c (E denotes expected future earnings using the firms current business technology, AV denotes adaptation value, c denotes capitalization factor of earnings).

The market value of equity curve is approaching the fixed adaptation value on the left of the point, and approaching capitalized expected earnings on the right of the point. For low expected future earnings, adaptation value does more contribution to market value of firm’s equity, and a revision in expected future earnings matters little for the valuation of a firm.

For high expected future earnings, however, recursion value does more contribution to market value of firm’s equity, and a revision of expected future earnings has a great impact on market value. For middle class of earnings, the market value is attributive to a more balanced combination of recursion and adaptation value. In this case, keeping adaptation value constant, the market value revision because of a change in the mean of expected future earnings depends on the level of the mean of expected earnings. The slope of the association between market value and expected earnings increases over the range of expected future earnings towards its limiting value, the earnings capitalization part.

Figure 1

Market value of equity as a function of expected earnings, holding adaptation value constant

Source: Burgstahler and Dichev (1997)

Note: The crossing point is of investor indifference where capitalized earnings (recursion value) are equal to adaptation value. For E > AV/c, investors are more willing to continue to operate the company using the current technology, while for E < AV/c, investors are more willing to adapt recourses to an alternative use.

2. Market value as a function of book value for fixed earnings

As a function of book value, the analysis of market value which holds earnings constant is similar to the analysis above. Rearranging and expanding the first equation as a function of AV for a fixed E, yields:

MV (AV, E) =cE +

In this form, the market value of equity on a condition that the sum of capitalized earnings plus the value of an option on downside protection can interpret a fixed level of expected earnings. That is to say, if the adaptation value proves superior the value of the firm, the value of a firm’s option to elect it is based on the earnings stream that is generated with the business technology at present. This equation provides the basis for a second proposition:

Proposition 2: On a condition of given expected earnings, market value is an increasing, convex function of adaption value.

In an intuitive sense, it holds because an increase in adaptation value provides additional downside protection for a fixed level of expected earnings. Furthermore, the higher the level of adaptation value associated with the fixed level of expected earnings, the larger the revision in market value relative to a revision in adaptation value. If the adaptation value is large associated with capitalized expected earnings, the business technology of the firm at present is inferior to alternatives, and adaptation value becomes the main determinant of market value of equity; recursion value is only a secondary determinant of market value of equity.

As is mentioned above, Burgstahler and Dichev (1997) found that the extent of association of equity values with earnings and book value depended on the level of success of the firm. When the firm is successful (high earnings), earnings is the more important determinant of equity value. While when the firm is less successful (low earnings), book value is the more important determinant of equity value. This finding is further confirmed by Collins et al. (1999). Specifically, it is concluded by Collins et al. (1999) that book value is an important factor to determine stock prices, especially for firms making loss. For firms that have a high probability of liquidating because of their financial losses, book value represents as a proxy for what they referred to as the “abandonment option”.

2.4 Studies examining Chinese stock market data

There are only a limited number of published studies that examine the variables driving equity value in the Chinese environment. The published research that is available has focus on the behavior of Chinese stock market and macro-control impact on the Chinese stock market. Liu et al. (2009) examined the main characteristic of Chinese stock price in their dissertation and showed that the significant of both skewness and tail-thickness in the condition of distribution of returns, and should be considered in making decisions regarding portfolio selection, market timing and VaR (value at risk) estimates when applies to emerging financial markets.

One group of studies investigates the behavior of Chinese stock prices. Deng and Ma (2005) explored the behavior of Chinese stock prices covering the period from 1998 to 2003. They examined whether stocks in the Chinese stock market conformed to the weak form of market efficiency, which maintains that all past information is reflected in the stock price and investors cannot earn excess returns based on historical information. They found that daily and weekly returns diverge from the random walk.

The behavior of monthly returns was analyzed to be inconsistent with the random walk hypothesis, which implies market inefficiency in pricing securities. These findings are consistent with the previous empirical studies on emerging stock markets. In addition to that, there are a number of studies focuses on the test of Fama-French Three-Factor model in Chinese stock market. Chen et al. (2003) reported that, similar to U.S. stock market, there was an obvious effect of small size company in Chinese stock market. It indicates that there is a inverse relationship between of the rate of return and an increase in the relative size of a Chinese company.

In conclusion, there are few researches in the international articles using Chinese data to analyze the factor influence Chinese stock price or examine the variables that drive equity values in Chinese environment. Therefore, a purpose of this dissertation is to make an empirical research whether the underlying economic behavior of stock valuation pertains in the new environment. Overall, what is expected is to find a certain association of earnings and book values with equity values of firms in China. Because in the developed markets, as already mentioned, earnings and book value can be used to predict firm value. Accordingly, both of the two factors should, to some extent, influence equity value in developing markets. Therefore, it would be useful to examine how the roles of recursive values (earnings) and adaptive values (book values) in the Chinese market differ from their roles in the developed world.

3 Methodology

To investigate the value relevance of earnings and book value in emerging market based on prior studies, Asokan et al. (2006) developed the following regression equations:

Pi,t /Bi,t-1 = α0 + β1(Ei,t /Bi,t-1) + ε1 [1]

Pi,t /Bi,t-1 = α1 + β2(Bi,t /Bi,t-1) + ε2 [2]

Pi,t /Bi,t-1 = α2 + β3(Ei,t /Bi,t-1) + β4(Bi,t /Bi,t-1) + ε3 [3]

Pi,t /Bi,t-1 = α3 +β5 M + β6 H + β7(Ei,t /Bi,t-1 )+β8 M(Ei,t /Bi,t-1 )+β9 H(Ei,t /Bi,t-1 )+ε4 [4]

Pi,t /Ei,t = α4 +β10 M + β11 H + β12(Bi,t-1 /Ei,t)+β13M(Bi,t-1 /Ei,t)+β14H(Bi,t-1 /Ei,t)+ε5 [5]

where

Pi,tis price per share (market value) of equity for firm i at the end of period t,

Ei,tis the annual earnings per share for firm i in period t,

Bi,tis book value per share for firm i at the end of period t,

M is a dummy variable [1 for firms with Medium earnings to book value ratio in Equation (4) and scaled book value in Equation (5) firms; 0 otherwise],

H is a dummy variable [1 for firms with High earnings to book value ratio in Equation (4) and scaled book value in Equation (5); 0 otherwise],

ε is a normally distributed error term.

To be consistent with prior researches, Asokan et al. (2006) followed Bowen (1981), Burgstahler and Dichev (1997) and Bao and Bao (1998) and normalized both the dependent and independent variable in Equations [1], [2] and [3] by the beginning book value per share. Besides, they preferred to use Bi,t-1 as the measure of book value of equity (adaptation value) for firm i at period t, since by definition Bit contained Ei,t as a component.

According to Burgstahler and Dichev (1997), empirical tests using Bit-1 will more clearly separate the effects of earnings (E) and book value of equity (B). The model represented by Equation [1] is to test whether price is positively associated with earnings. The model represented by Equation [2] is to test whether price is positively associated with book value. The model represented by Equation [3] uses an additive form of earnings and book value based on Ohlson (1995), who postulated that firm value is a linear function of both earnings and book value. Equations [4] and [5] examine how the relationship of earnings and book value to price is moderated by the success level of firms. Dummy variables are included to represent successful or high earnings (H), unsuccessful or low earnings (L), and middle of the road firms (M).If the firm is successful (high earnings) and is likely to continue in operation, then earnings will be a significant variable associated with stock price. However, if a firm is unsuccessful (low earnings) then it will attempt to find alternative uses for its resources to survive. For these firms, book value than earnings will be a significant variable effect stock price. In a similar way, for middle-of-the-road firms, equity value will be significantly associated with both earnings and book values. Two cut off points are determined for each time period to ensure an equal number of samples in each group using the ranking according to Eit / Bit-1 for Equation [4] and Bit-1/Eit for Equation [5] (Asokan et al. ,2006).

4 Data

4.1 The panel data of earnings, book value and market value

The data used in this study come from CEIC and WIND databases. Following Fama and French (1992), Burgstahler and Dichev (1997), Bao and Bao (1998) and Asokan et al. (2006), non-financial firms as well as firms with negative book value of stockholders’ equity are excluded. In addition, some firms were deleted because of missing share performance information. The frequency of the data is semiannual and extends from the first half year of 2001 to the second half year of 2008. The data consists of a total of 1002 firms of Chinese industrial firms in a time period for sixteen-time periods. In the firms making up the sample in a time period, 471 firms are traded in the SZSE, 531 firms are traded in SHSE.

In the samples, Pi,t is price per share (market value) of equity for firm i at the end of period t; Ei,t is the annualized earnings per share for time I in period t; Bi,t is the book value per share for firm i at the end of time t. The samples are classified into three groups, the cutoff points are determined to ensure an equal number of observations in each group using the rankings according to Ei,t /Bi,t-1 for Equation [4] and Bi,t-1 /Ei,t for Equation [5]. The three groups are: L for unsuccessful firms or low earnings firms (earnings less than Cut off 1), M for middle of the road firms (earnings between Cut off 1 and Cut off2) and H for successful firms or high earnings firms (earnings greater than Cut off 2). As mentioned above, unsuccessful firms (L) are excluded from the regressions as the base case (Asokan et al. 2006).

Using ordinary least squares, as regression proposed by White (1980), a consistent estimate of covariance matrix allowing heteroscedasticity should be computed. The coefficient themselves do not change, only the standard deviations. Moreover, in order to control for distorted results because of possible extreme observations, any observation are omitted for which the residual was larger than three standard deviations for each of the five models. This ensures that the results are not driven by outliers. (Asokan et al. 2006)

4.2 Analysis

Descriptive statistics for the data are shown in Table 2. As can be observed, the ratio of market to book value shows wide fluctuations over time, as evidenced by high standard deviation values and substantial changes in the mean values across periods. In the recent years, the potential for Chinese stock market growth has attracted foreign institutional investors and global investors. The annual rates of return for the Shanghai and Shenzhen composite indices in China were 81.7 percent and 66.3 percent during 2006 respectively (Liu et al. 2009).

At the same time, this rapid growth has been accompanied by high risk. Generally, however, the mean values decrease from 2001 to the end of 2006, and the standard deviation values tend to become small from 2001 to the middle of 2006. Although both the mean values and the standard deviation value increase from 2006 to the end of 2008, they are not as high as the values at beginning of the sample period. This downward trend may be a reflection of the level of maturity in Chinese stock market as a result of the development and improvement of Chinese economy and stock market in nearly 20 years.

After 1999, at the background of favorable balance of trade, the market entered a process of fast increase. The growth of favorable balance of trade can give an impetus to the revaluation of assets. It is important not only to the reasons for the favorable balance of trade could have a large number of mobility; and the expansion of favorable balance of trade is a reflection of the fact that excess capacity, the existence of excess production capacity to suppress inflationary pressures in the economy, resulting in more generous monetary and credit creation process in reality.

Therefore, in the view of the revaluation of assets, the trade surplus and capital inflows can be formed to create liquidity, but through different channels acting on inflation, then creating credit to support and promote the rise in asset prices. This situation lasted for about two years. Of course, the creation of liquidity may also be accompanied by the expansion of economic activity and inflation pressures increased, rather than the expansion of asset prices, such as the year before and after 2003 in China.

The increase in credit market interest rates in the fourth quarter in 2007 is a turning point; it reversed the continued downward trend in interest rates in the third quarter of 2005. At the same time, the revaluation of the Chinese market and the increase of the process of synchronization is a decline in interest rate, and the market period of decline in other basic synchronization is also a rise in interest rates. Since the first quarter of 2008, the stock market in China has been far beyond expectations of all the investors for the rapid decrease in the large scale of stock price.

From the point of view liquidity supply, the trend of capital inflows may be the maintenance of high and even expanding; taking the changes in the direction of the real economy into account, the trend of credit control may be tight after the first song, as well as, the trend in the supply of liquidity should be about high after the first low. In other words, in the short term, the credit control leads to tighter liquidity or even shortage, the existence of asset markets may also have some pressure, the pressure can track from changes in interest rates in the credit market and consider the imbalance of the market itself to infer. In the medium to long term, the trend of assets revaluation is still clear and the bull market in China will still exist.

The average earnings as a percentage of book value also exhibit large variation over period. What is interesting is that the in China average earnings scaled by book value are higher than in more advanced countries. This difference in earnings may be an influence of the degree of business risk associated with the specific economic environment in China. The environment in the developed markets is more competitive as firms have to compete not only with many domestic competitors but also with many foreign rivals.

But the business environment in China is not so open and less competitive. Chinese companies are protected from internal and external competition with entry barriers and large scale and numbers regulation. In addition to that, many sectors in China, such as high-tech sectors, electronically communication sectors and industrial sectors etc., are highly concentrated and control is dominated by some very large companies, the typical characteristics of an oligopolistic market that yield high profits.

Table 2

Summary statistics of Chinese firm’s Market value (Pt), Earnings (Et) and Book Value (Bt) scaled by Book Value (Bt-1) between 2001-6-30 and 2008-12-31

Note: Pi,t is price per share (market value) of equity for firm i at the end of period t; Ei,t is the annualized earnings per share for firm i in period t; Bi,t is book value per share for firm i at the end of period t. Following Bowen (1981), Burgstahler and Dichev (1997) and Bao and Bao (1998), the variables are normalized by beginning net book value per share.

5 Empirical results

Table 3 shows coefficient estimates for the simple linear equation which is relating Pit / Bit-1 to Eit / Bit-1 (Eq. [1]). Results are exhibited for regressions which are conducted for semi-annual period from 2001 to 2008. As indicated in Table 3, the coefficient on earnings is positively significant for all years under study. This suggests that, in China, earnings are important in terms of information content and associated with stock price significantly.

In addition to that, as can be observed in Table 3, t1 (the t-statistic for β1) is rises across the years, that is to say, when it is moved to more recent years, the value of the coefficient increases. The estimates, however, show a wide fluctuation over the sample period. An explanation is that the change can be attributed to a general increase in the importance of earnings over the years in Chinese economic environment. 

Table 3

Market value of Chinese companies as function of earnings between 2001-6-30 and 2008-12-31

Note: tα0 is the t-statistic for α0; t1 is the t-statistic for β1. The statistical significance for tα0 and t1 is at 5% level. Pi,t is price per share (market value) of equity for firm i at the end of period t; Ei,t is the annualized earnings per share for firm i in period t; Bi,t is book value per share for firm i at the end of period t. Following Bowen (1981), Burgstahler and Dichev (1997) and Bao and Bao (1998), the variables are normalized by beginning net book value per share.

Table 4 shows estimates of the coefficients for the simple linear equation which is relating Pit / Bit-1 to Bit / Bit-1 (Eq. [2]). As exhibited in Table 4, the coefficient for book value is positively significant for all the years under study. This means that book values is significantly associated with stock price for the time period as sample. What is interesting is that because the adjusted R2 is higher for half of the period regressions, the estimates in Table 4 indicate that there is a more important relation between book value and equity value than earnings. In the specific environment of China, book value seems to be more important to investors in equity value of a firm.

As Burgstahler and Dichev (1997) claim, within a turbulent economic environment the adaptation value may play a more important role than the recursion value. Since it is relatively not easy to determine the market value of an asset by projecting future expected earnings in an unstable business environment than in a stable one, it may be that Chinese investors give more weighting to the value of assets more than their potential value. In a volatile environment, where companies’ losses and failures are common, it seems that investors concern less about future expected earnings that may not be realized. The average adjusted R2 for Model 2 in Table 4 (approximately 55%) is also higher than that of Model 1 in Table 3 (46%), showing a stronger relation between book value and equity values than between earnings and equity values of firms. 

Table 4

Market value of Chinese firms as function of book value between 2001-6-30 and 2008-12-31

Note: tα1 is the t-statistic for α1; t2 is the t-statistic for β2. The statistical significance for tα1 and t2 is at 5% level. Pi,t is price per share (market value) of equity for firm i at the end of period t; Ei,t is the annualized earnings per share for firm i in period t; Bi,t is book value per share for firm i at the end of period t. Following Bowen (1981), Burgstahler and Dichev (1997) and Bao and Bao (1998), the variables are normalized by beginning book value per share.

The market value of a firm can be considered a function of both earnings and book value. A firm has the option to either continue its business at present or adapt its resources to alternative uses. Table 5 contains estimates of the coefficients for the linear equation that is relating Pit / Bit-1 to Eit / Bit-1 and Bit / Bit-1 (Equation [3]). In Table 5, the coefficients on both earnings and book value are significant at 5% level for all the years under study. While both earnings and book values are associated with equity values individually in the empirical results above, they are more powerful in explaining value when they are combined.

The average adjusted R2 is higher for the regressions than that of the model in Table 3 and Table 4. At the same time, what we should pay attention to is that although the coefficients of earnings tend to become as big as those of book value when it is moved to more recent years, the average coefficient and significance of book value is higher than those of earnings. It supports the argument that book value plays a more important role in the equity value of a firm than earnings.

Table 5 Market value of Chinese firms as function of earnings and book value between 2001-6-30 and 2008-12-31

Note: tα2 is the t-statistic for α2; t3 is the t-statistic for β3; t4 is the t-statistic for β4. The statistical significance for tα2, t3 and t4 is at 5% level. Pi,t is price per share (market value) of equity for firm i at the end of period t; Ei,t is the annualized earnings per share for firm i in period t; Bi,t is book value per share for firm i at the end of period t. Following Bowen (1981), Burgstahler and Dichev (1997) and Bao and Bao (1998), the variables are normalized by beginning book value per share.

Table 6 reports estimates of the coefficients for the piece-wise form which is relating Pit / Bit-1 to Eit / Bit-1after controlling for firm success (high earnings firms) (Equation [4]). Table 7 contains estimates of the coefficients for the piece-wise form which is relating Pit / Bit-1 to Bit-1 / Eitafter controlling for firm success (high earnings firms) (Equation [5]). As mentioned earlier, the domains of Eit / Bit-1(Table 6) and Bit-1 / Eit(Table 7) are divided into three groups with equal numbers of firms under study.

In Table 6, for example, the groups were identified in 2001-6-30 as follows: the firms with the ratio of Eit / Bit-1less than 0.201 (Cutoff 1) to the unsuccessful or low earnings firms (L), which is excluded from the regressions as the base case; the firms with the ratio of Eit / Bit-1greater than 0.201 (Cutoff 1) but less than 0.441 (Cut off 2) to the middle of the road firms (M); and the firms with the ratio of Eit / Bit-1greater than 0.441 (Cutoff 2) to the successful or high earnings firms (H). The same grouping procedure is practiced for Bit-1/ Eit in Table 7.

According to Asokan et al. (2006), the slope and intercept coefficients for the middle of the road companies (β5 andβ8) and successful companies (β6 andβ9) were estimated incremental to the slope and intercept coefficients of unsuccessful companies (α3 and β7). The procedure above closely follows the treatment of Burgstahler and Dichev (1997). Because of doing so, the purpose is to test whether the incremental coefficients are equal to zero. In this case, the t-statistics which is given in the tables for the successful or high earnings companies (H) and middle of the road companies (M) are for tests of incremental significance relative to the group of the unsuccessful or low earnings companies (L).

However, it should be noted that the coefficients exhibited in the tables are the total slope and intercept coefficients for the group M, that is to say, β7+β8 for the slope andα3+β5 for the intercept; and the total coefficients for the group H, β7+β9 for the slope andα3+β8 for the intercept. Therefore, t8 shown in Table 6 is the relevant t-statistics for testing whether the difference between slope coefficients of the middle of the road companies (M) and unsuccessful or low earnings companies (L) is significant, that is, whether β8 is zero.

Similarly, t9 is the relevant t-statistics for testing whether the difference between slope coefficients of the successful or high earnings companies (H) and unsuccessful or low earnings companies (L) is significant, that is, whetherβ9 is zero. At the same time, different cut offs were conducted by using quartiles and were not different significantly. It means that the method of cut offs for differentiating successful or unsuccessful firms did not significantly influence the results.

As the results showed in Table 6, there is a positively significant relationship between scaled market value and scaled earnings (β7 is significantly different from zero and positive). This result supports the market value relevance of earnings. Consistent with the valuation model, the average intercepts of Equation [4] decline as earnings scaled by book value rise across groups [(α3+β6 = 0.195)< (α3+β5 = 0.637)< (α3= 1.455)]. Additionally, the slope coefficients generally rise as the low earnings group is shifted from to high earnings group as also forecasted by the convexity theory [(β7+β9 =15.258)>(β7+β8 =13.276)>(β7 =9.498)]. At the same time, the explanatory power of Model 4 is much larger than that of the Model 1, which infers that the piece-wise form fits the data better than the simple linear form.

Table 7 reports the results for the piece-wise function of book value which is controlling for the level of earnings. As the results indicate, book value is more relevant for valuation of equity for unsuccessful firms because the intercepts decrease as the book value increase. The average intercepts of Equation [5] rise as book value scaled by earnings rise across groups [(α4+β11 = 1.086)< (α4+β10 = 5.240)< (α4= 14.401)]. In addition, consistent with expectations, the slope coefficients regularly rise across the groups: [(β12 =-0.505)<(β12+β13 =1.319)<(β12+β14=1.932)]. -0.505 for unsuccessful companies (low ratio of BV/E value); 1.319 for the middle of the road companies (medium ratio of BV/E value); and 1.932 for the successful companies (high ratio of BV/E value).

The coefficients estimates on earnings and book values are consistent with their values in theory and findings of Burgstahler and Dichev (1997) for U.S. companies. However, though the results are similar showing similar relationships, a difference is that the models which use Chinese data had much bigger adjusted R2s than the model in the Burgstahler and Dichev (1997) research. In the case of the first linear model (Equation [1]) which contains earnings as the dependent variable, the research of Burgstahler and Dichev (1997) reported an average adjusted R2 of 0.11, that is, approximately 10%. In this study, however, an average adjusted R2 of 0.408 by using Chinese stock market data, approximately 40%.

The much relevant results with Chinese data mean that, a great number of variables may be impacting equity values in the U.S. or developed markets. In a developing market like China, however, equity value of a firm may be influenced by only some very limited variables. In the relatively smaller, limited and less complex capital market of China, the restricted disclosure of information to investors as well as small number of market participants may be among the reasonable reasons on a basis of this observation.

Table 6 Market value of Chinese firms as function of earnings with dummy variables to represent successful and middle of the road firms between 2001-6-30 and 2008-12-31

Note: tα3 is the t-statistic for α3; t5 is the t-statistic for α3+β5; t6 is the t-statistic for α3+β6; t7 is the t-statistic for β7; t8 is the t-statistic for β7+β8; t9 is the t-statistic for β7+β9. The statistical significance for tα3, t5, t6, t7, t8 and t9 is at 10% level. Pi,t is price per share (market value) of equity for firm i at the end of period t; Ei,t is the annualized earnings per share for firm i in period t; Bi,t is book value per share for firm i at the end of period t. The table contains estimates of the coefficients for the piece-wise form relating Pi,t/Ei,t to Bi,t/Ei,t after controlling for firm “success” . The samples were classified into successful or high earnings’ firms (H), middle of the road (M), and unsuccessful or low earnings’ firms (L). Unsuccessful firms (L) are excluded from the regressions as the base case.

The cutoff points for this classification are determined in a way that there will be an equal number of observations, 334 firms, in each group using the rankings according to Ei,t/Bi,t-1. The cut-off points for the respective periods are given in the last two columns. Accordingly, the unsuccessful or low earnings firms (L): firms with Ei,t/Bi,t-1 less than Cutoff1, middle of the road firms (M): firms with Ei,t/Bi,t-1 between Cutoff1 and Cutoff2, and successful or high earnings firms (H): those with Ei,t/Bi,t-1 greater than Cutoff2. According to White 1980, all t-statistics are calculated based on the heteroscedasticity-consistent covariance matrix. The t-statistics for the groups H and M are the t-statistics for tests of the hypothesis that the coefficients for the H and M group firms are significantly different from the corresponding coefficient for the L group.

Table 7 Market value of Chinese firms as function of book values with dummy variables to represent successful and middle of the road firms between 2001-6-30 and 2008-12-31

Note: tα4 is the t-statistic for α4; t10 is the t-statistic for α4+β10; t11 is the t-statistic for α4+β11; t12 is the t-statistic for β12; t13 is the t-statistic for β12+β13; t14 is the t-statistic for β12+β14. The statistical significance for tα4, t10, t11, t12, t13 and t14 is at 10% level. The table contains estimates of the coefficients for the piece-wise form relating Pi,t/Ei,t to Bi,t/Ei,t after controlling for firm “success” . The samples were classified into successful or high earnings’ firms (H), middle of the road (M), and unsuccessful or low earnings’ firms (L).

Unsuccessful firms (L) are excluded from the regressions as the base case. The cutoff points for this classification are determined in a way that there will be an equal number of observations, 334 firms, in each group using the rankings according to Bi,t/Bi,t-1. The cut-off points for the respective periods are given in the last two columns. Accordingly, the unsuccessful or low earnings firms (L): firms with Bi,t/Bi,t-1 less than Cutoff1, middle of the road firms (M): firms with Bi,t/Bi,t-1 between Cutoff1 and Cutoff2, and successful or high earnings firms (H): those with Bi,t/Bi,t-1 greater than Cutoff2.

According to White 1980, all t-statistics are calculated based on the heteroscedasticity-consistent covariance matrix . The t-statistics for the groups H and M are the t-statistics for tests of the hypothesis that the coefficients for the H and M group firms are significantly different from the corresponding coefficient for the L group.

6 Conclusions

In accounting research for the past three decades, earnings have been recognized the most important determinant of equity value of a firm. Ohlson (1995) modeled equity value of a firm as a linear function of both earnings and book value. Burgstahler and Dichev (1997) reported that equity value of a firm is a piece-wise function and not a linear additive function of both earnings and book value. U.S. markets and firms are focused by all major studies. The United States possesses a characteristic that is a strong well-established stock market with a multiplicity of investors. What’s more, none of the investors can influence the stock market individually.

In this dissertation, whether earnings and book value have a similar relationship in the Chinese stock market that has different characteristic was examined. China, at present, is an emerging market that has adopted liberal policies in the last three decades. The Chinese stock market has fewer companies relative to the United States. On one hand, it is also relatively inefficient because a few large investors can influence stock prices significantly by their activity of buying and selling. On the other hand, there is some difference in accounting methods between the two markets. 

The purpose of this dissertation is to examine whether the relationship between earnings, book value and equity value of a firm still holds in this different economic environment. What is found is that the associations do hold in Chinese market but the degree of the relationship is different. Overall, in China, earnings indeed have information content and are relevant to forecast equity value of a firm after the control of book value.

The importance of earnings, however, seems to be not that high as a predictor of equity value. Book value has a stronger relation to equity value in this environment. The fact that in the immature market of China it is too difficult to determine market value by forecasting future expected earnings may explain this difference. In a unstable and immature economic environment in which book value of earnings is quite uncertain, investors may be paying attention to other factors rather than earnings. At the same time, Chinese investors may have found this criterion and applied it well.

The importance of book value in valuing equity has been denied by some researches. Bath and Kallapur (1996), for example, noted that book value was only important because of its contribution as a control for scale differences. Others have arrived at different conclusions by considering the role of book value. Ohlson (1995) and Penman (1992) concluded that the important role book value played because it was a useful proxy for expected future normal earnings.

Still, others reported that it was important but for a different reason. For example, Berger et al. (1996), Bath and Kallapur (1996) and Burgstahler and Dichev (1997) concluded that book value had a great contribution as a value proxy for unsuccessful companies. This study shows that book value is important in an unstable economic environment and immature stock market, like China, which is still in early stage of capital market.

The results, specifically, indicate that earnings and book values have significant relation to equity valuation. The combination of the two factors has a strong relation to equity values. Finally, when the sample is partitioned, what has been found is that earnings play a more important role in valuation of equity of successful companies, while book value has more contribution in valuation of equity of unsuccessful companies. This is consistent with the findings of Burgstahler and Dichev (1997). To be concluded, the models using the data of Chinese firms have a high adjusted R2. This may show that in this developing country, only a few factors are influenced the stock price.