An Analysis of Historical and Future†Oriented Information in Accounting†Based Security Valuation Models

The Ohlson (1995) and Feltham and Ohlson (1995) valuation model provides a rigorous framework for summarizing the information in expected future earnings and book values. However, the model provides little guidance on selecting an empirical proxy for expected future earnings. We examine whether and under what circumstances historical earnings and analyst earnings forecasts offer comparable explanation of security prices. This issue is of particular interest because analyst forecasts are less readily available than historical data. Under appropriate circumstances, historical data may allow wider use of the Feltham†Ohlson valuation model by researchers and investors. A related issue is the incremental explanatory power of historical earnings and realized future earnings (perfect†foresight forecasts) for security prices beyond analyst forecasts. If historical earnings are incrementally informative, that would suggest that analyst forecasts do not fully reflect price†relevant information in past earnings. If future earnings are incrementally informative, that would suggest that security prices reflect investors' implicit earnings forecasts beyond analyst forecasts. We examine these issues using a historical model (based on past earnings), a perfect†foresight model (based on realized future earnings), and a forecast model (based on Value Line earnings forecasts). All three models provide significant explanatory power for security prices, and each set of earnings data provides incremental explanatory power for prices when used with the other sets of earnings data. We estimate the models separately for firms with moderate and extreme earnings†to†price (E/P) ratios, a proxy for earnings permanence. For moderate†E/P firms, the historical model's explanatory power exceeds that of the perfect foresight model, and is indistinguishable from that of the analyst forecast model. In contrast, for extreme†E/P firms, the perfect†foresight model offers greater explanatory power than the historical model, but lower explanatory power than analyst forecasts. Our results suggest that financial analysts' forecasting efforts are best focused on firms whose earnings contain large temporary components (extreme E/P firms). However, in general, both historical data and analyst forecasts are complementary information sources for security valuation.