Consumption, Residual Income Valuation, and Long-run Risk

This paper develops a theoretical extension of the residual income valuation model that integrates the concept of long-run risk. The model starts with an intertemporal framework, assumes the clean surplus accounting relation, and expresses firm market value as the book value of equity plus the present value of expected future residual income. The main finding of the extension model indicates that a firm’s goodwill is negatively related to its accounting risk, measured by the long-run covariance of the firm’s abnormal earnings growth and aggregate consumption growth. In the context of the residual income valuation method, this finding suggests that the earnings-consumption covariance (in the long run) represents an appropriate accounting risk measurement of a firm’s intrinsic value