Recently, much of the research into the relation between market values and accounting numbers has used, or at least made reference to, the residual income model (RIM). Two basic types of empirical research have developed. The “historical” type explores the relation between market values and reported accounting numbers, often using the linear dynamics in Ohlson 1995 and Feltham and Ohlson 1995 and 1996. The “forecast” type explores the relation between market value and the present value of the book value of equity, a truncated sequence of residual income forecasts, and an estimate of the terminal value at the truncation date. The analysis in this paper integrates these two approaches. We expand the Feltham and Ohlson 1996 model by including one- and two-period-ahead residual income forecasts to infer “other” information regarding future revenues from past investments and future growth opportunities. This approach results in a model in which the difference between market value and book value of equity is a function of current residual income, one- and two-period-ahead residual income, current capital investment, and start-of-period operating assets. The existence of both persistence in revenues from current and prior investments and growth in future positive net present value investment opportunities leads us to hypothesize a negative coefficient on the one-period-ahead residual income forecast and a positive coefficient on the two-period-ahead residual income forecast. Our empirical results strongly support our hypotheses with respect to the forecast coefficients.

Abstract Recently, much of the research into the relation between market values and accounting numbers has used, or at least made reference to, the residual income model (RIM). Two basic types of empirical research have developed. The “historical” type explores the relation between market values and reported accounting numbers, often using the linear dynamics in Ohlson 1995 and Feltham and Ohlson 1995 and 1996. The “forecast” type explores the relation between market value and the present value of the book value of equity, a truncated sequence of residual income forecasts, and an estimate of the terminal value at the truncation date. The analysis in this paper integrates these two approaches. We expand the Feltham and Ohlson 1996 model by including one‐ and two‐period‐ahead residual income forecasts to infer “other” information regarding future revenues from past investments and future growth opportunities. This approach results in a model in which the difference between market value and book value of equity is a function of current residual income, one‐ and two‐period‐ahead residual income, current capital investment, and start‐of‐period operating assets. The existence of both persistence in revenues from current and prior investments and growth in future positive net present value investment opportunities leads us to hypothesize a negative coefficient on the one‐period‐ahead residual income forecast and a positive coefficient on the two‐period‐ahead residual income forecast. Our empirical results strongly support our hypotheses with respect to the forecast coefficients.

We consider a setting in which a firm uses residual income to motivate a manager's investment decision. Textbooks often recommend adjusting the residual income capital charge for market risk, but not for firmspecific risk. We demonstrate two basic flaws in this recommendation. First, the capital charge should not be adjusted for market risk. Charging a market risk premium results in “double” counting because a risk-averse manager will personally consider this risk. Second, while investors can avoid firm-specific risk through diversification, a manager cannot. If the manager faces significant firm-specific risk at the time he makes his investment decision, then it is optimal to charge him less than the riskless return so as to partially offset his reluctance to undertake risky investments. On the other hand, the manager will vary his investment decisions with the pre-decision information he receives, which accentuates his compensation risk, and the firm must compensate him for bearing this additional risk. Hence, if the manager will receive relatively precise pre-decision information, then it is optimal to charge him more than the riskless return to reduce the variability of his investment decisions.