Gerald A. Feltham

Peter O. Christensen

We review and critically examine the standard approach to equity valuation using a constant risk-adjusted cost of capital, and we develop a new valuation approach discounting risk-adjusted fundamentals, such as expected free cash flows and residual operating income, using nominal zero-coupon interest rates. We show that standard estimates of the cost of capital, based on historical stock returns, are likely to be a significantly biased measure of the firm's cost of capital, but also that the bias is almost impossible to quantify empirically. The new approach recognizes that, in practice, interest rates, expected equity returns, and inflation rates are all stochastic. We explicitly characterize the risk-adjustments to the fundamentals in an equilibrium setting. We show how the term structure of risk-adjustments depends on both the time-series properties of the free cash flows and the accounting policy. Growth, persistence, and mean reversion of residual operating income created by competition in the product markets or by the accounting policy are key determinants of the term structure of risk-adjustments.

Equity Valuation

William T. Ziemba

Amin H. Amershi

The three coeditors knew John Butterworth for many years and had worked closely with him on a number of research projects. We respected him as a valuable colleague and friend. We were greatly saddened by his untimely death. This book is an attempt to remember him. We dedicate the volume to John with thanks for the contributions he made to our research, to the Faculty of Commerce and Business Administration at the University of British Columbia, and to the accounting profession. This volume contains twelve invited papers on the general topic of the economic theory of information and contracts. We asked leading scholars who had known John to contribute papers. The response was very gratifying. The authors provided us with new strong research papers that should make a lasting contribution to the accounting and information economics research literature, and make us all proud to have put this volume together. The research papers in the volume are in three sections: information evaluation in multi person conte)l:ts; contracting in agencies under moral hazard; and contracting in agencies with private information. We begin part I with Jerry Feltham's review of John Butterworth's pioneering contributions to the accounting and information economics literature. This is followed by an introduction to the papers in the volume and the papers themselves.

Gerald A. Feltham

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