Equity valuation in practice: The influence of net financial expenses

Highlights

•	I analyse how net financial expenses associate with market prices of stocks.

•	The empirical study finds that financial items are not value relevant under IFRS.

•	The study concludes that equity values are driven by operating items.

•	The residual operating income model is appropriate for equity valuation.

Abstract

This study investigates the relevance of net financial expenses with respect to equity valuation in an IFRS accounting regime. According to the residual earnings valuation model, income related to balance sheet items that are recorded at fair value is not applicable for valuation purposes. There are no residual earnings associated with these items because the balance sheet provides ‘perfect’ value estimates for the items in question. In accordance with the contention that under IFRS, aggregate net financial liabilities are recorded at a book value that is close to fair value, this study demonstrates that net financial expenses are not associated with the market prices of stocks. The investigation discusses the empirical findings in light of the enduring controversies regarding the use of fair value accounting.

Keywords:

• Value relevance
• Net financial expenses
• Residual earnings
• Operating income
• Equity valuation
• Fair value accounting

Acknowledgements

I would like to thank Dennis Frestad, Andre Tofteland, Roy Mersland, an anonymous reviewer and Glen Lehman (the editor) for helpful suggestions and comments.

Notes

1 The European Union required all exchange-listed firms within the European Economic Area (EEA) to adopt IFRS in their consolidated financial statements on January 1st, 2005. The EEA consists of Norway, Iceland, Lichtenstein and the EU nations.

2 Christensen and Feltham (2003) demonstrate how the price model can be deduced from the residual earnings model. An important assumption of this deduction is that the previous year's earnings for a firm contain information relevant to the prediction of the firm's future residual earnings.

3 Other comprehensive income (dirty surpluses) that may arise from changes in the values of financial assets and liabilities is not included in the FINPS. The analysis of this study focuses exclusively on earnings items that are reported on the income statement. Note that in any event, these types of ‘dirty surpluses’ arise from financial items that are recorded at fair value (thus, the discussion of whether the balance sheet values for these items are ‘close enough’ to fair value is irrelevant).

4 See, e.g., the study by Danbolt and Rees (2008) that addresses the use of fair value accounting for real estate valuations. Barth and Taylor (2010) argue that possible earnings management should be blamed on the managers and other entities who conduct these manipulations rather than on the accounting system. Moreover, although fair values can be manipulated, accounting values under other accounting regimes may be manipulated even more readily (Barth and Taylor, 2010, p. 32).

5 In a perfect fair value accounting regime, earnings are not informative about equity value. In this situation, the (exact) value of a firm's equity is provided by its balance sheet (cf. Danbolt and Rees, 2008). However, earnings are informative with respect to a firm's risk. In particular, the P/E ratio under historical cost accounting has clear interpretations for firm valuation, whereas the P/E ratio under fair value accounting becomes a measure of risk. Nissim and Penman (2008) provide a comprehensive description of the valuation consequences of fair value and historical cost accounting.

6 Notably, economic stability is not consistently present during the entire sample period of this study. For instance, during the recent financial crisis, the stock market plummeted by almost 65% (from 22 May 2008 to 21 November 2008; see Beisland, 2013).