Asian Economic and Financial Review FIRM S LIFE CYCLE AND OHLSON VALUATION MODEL: EVIDENCE FROM IRAN

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1 Asin Economic nd Finncil Review journl homepge: FIRM S LIFE CYCLE AND OHLSON VALUATION MODEL: EVIDENCE FROM IRAN Hossein Etemdi Forough Rhimi Mougouie 2 * 1 Deprtment of Accounting, Trbit Modres University, Irn 2 Trbit Modres University, Irn ABSTRACT Ohlson prediction nd vlution models Ohlson (1995) re bsed on firm book vlue, ccounting profit nd the ssumption of "rndomized, blnced nd stbilized bnorml ernings". On the other hnd, the significnce of risk nd performnce indictors during the firm s life cycle is different ccording to the life cycle theory. This literture represents the linkge of these indictors with the firm s vlue in different life cycle stges. In this study which is imed to review the bility to improve the Ohlson vlution model considering the firm s life cycle vrible, smple of firms listed in Tehrn Stock Exchnge between 2003 nd 2013 ws selected. Using Anthony nd Rmesh (1992) vribles nd Prk nd Chen (2006) methodology, the life cycle ws divided into three stges nd then, considering the firm s plce in the life cycle, prediction models of bnorml ernings nd Ohlson firm s vlution Ohlson (1995) were djusted nd fterwrd the djusted models were compred with the initil model in two short-term nd long-term estimtion periods of 5 nd 10 yers, respectively. The results show tht during both estimtion periods, the djusted model hs better performnce in predicting bnorml ernings nd firm s vlution compred to the initil model. During the 10-yer estimtion period, the two models estimted vlues were significntly less thn ctul vlues. The probble reson for this difference is the shrp rise in the vlue of stocks during the finl yers of the period especilly between 2012 nd AESS Publictions. All Rights Reserved. Keywords: Firm vlution, Firm life cycle, Abnorml erning, Ohlson vlution model, Growth, Decline, Mturity. JEL Clssifiction: M41, G11, G12. Contribution/ Originlity The pper's primry contribution is providing superior model for firm vlution by considering firm's life cycle. While previous studies hve shown the reltionship between the *Corresponding Author 641

2 ccounting vribles with firm vlue t different stges of the life cycle, none of them ddressed djustment the vlution model using this vrible. 1. INTRODUCTION Cpitl mrket prticipnts re lwys looking for vlue stocks nd vlid vlution method which will led them into stock inherent vlue. Since then, severl studies hve been conducted to predict stock prices, ech of which hs deemed effective one or more vribles thn other vribles on the stock price chnges. So they hve tried to control other vribles in order to study the effect of the vribles considered on the price chnges. In generl, studies conducted show n increse in the role of book vlue in stock vlution nd the reltionship of this vrible with firms mrket vlue Penmn nd Souginnis (1998). As in recent yers, Ohlson (1995) nd Felthm nd Ohlson (1995) models hve become lndmrk works in ccounting dt. Ohlson (1995) suggests tht the firm s vlue is ffected by three fctors of the firm book vlue residul ernings nd other informtion so tht we cn fix vlue close to the inherent vlue in order to determine fir vlue in the cpitl mrket. (Frnkel nd Lee, 1998; Dechow et l., 1999; Cllen nd Morel, 2001) nd Khodddi nd Emmi (2010) re mong the reserchers who hve exmined the role of ccounting dt in determining the firm s vlue using the Ohlson model Ohlson (1995). The results of some of these investigtions (such s Myers (1999)), Dechow et l. (1998), nd Frnkel nd Lee (1998), indicte tht the estimted vlues of this model re significntly less thn the ctul vlues.(dechow et l., 1999; Myers, 1999; Frncis et l., 2000; Lo nd Lys, 2000; Cllen nd Morel, 2001; Ot, 2002) nd Giner nd Iniguez (2006b) re mong the reserchers to hve tried to correct the Ohlson model Ohlson (1995) to rise its ccurcy in predicting bnorml ernings nd firm vlue. The life cycle theory of business entity ssumes tht the ltter presents different chrcteristics in different stges of the life cycle. Therefore, selected strtegies nd performnce mesures cn be different in different stges Kllunki nd Silvol (2008). The vlue of business entities is influenced by internl fctors, such s the choice of strtegy, finncil resources nd bility to mnge, nd externl fctors, such s competitive environment nd mcroeconomic fctors. Firm s life cycles re different stges creted by the chnge of these fctors; most of these chnges re due to strtegic ctivities selected by the firm Dickinson (2011). In recent yers, studies hve been conducted on the difference of risk nd performnce indictors during the firm s life cycle (including (Anthony nd Rmesh, 1992; Blck, 1998; Kllunki nd Silvol, 2008; Dickinson, 2011). The min messge of these studies is tht the vlue ssigned to criterion by cpitl mrket prticipnts depends on the reltive importnce of this criterion in certin stge of life cycle. This study tries to test nd exmine the cpcity of the firm s life cycle in order to present better vlution pttern. While previous litertures hve directly studied the effect of the life cycle on vlue relevnt to ccounting ernings, this reserch is importnt becuse it investigtes how the life cycle ffects the reltionship between ccounting vribles nd the firm vlue. 642

3 The second section of this study dels with literture review nd theoreticl frmework. In the third section, the reserch design is indicted nd the fourth section sttes the reserch findings nd, finlly, the conclusions re discussed. 2. STUDY OF LITERATURE REVIEW AND THEORETICAL FRAMEWORK Ohlson (1995) showed tht the firm s inherent vlue is equl to the book vlue of shreholders plus the current vlue of subsequent bnorml ernings. The ltter is equl to ccounting erning nd expected return on equity (discount rte multiplied by the book vlue). The inherent vlue is lso equl to the future dividend vlue, regrdless of interest pyment policies nd/or qulity of ccounting items. The dvntge of Ohlson perspective which hs stimulted growing body of reserches is tht it recognizes the potentil effect of retined ernings on future ernings. For instnce, if firm retins gret prt of its ernings, nturlly one cn expect tht due to the dvntge of excess ernings obtined by retined ernings, it will obtin higher future ernings. Other dvntges of the Ohlson perspective re the shift from excessive concentrtion on erning to profitbility. In his view, difference between the book vlue nd the mrket vlue is possible only when we expect tht the firm systemticlly erns from its ssets, which is different from expected rte of return of the mrket. Dechow et l. (1999) ssert tht the rel chievement of Ohlson (1995) nd Felthm nd Ohlson (1995) is tht the liner models presented by them crete link between current dt nd the firm s inherent vlue. The min contribution of this model is to provide s old theoreticl frme work for the vlution of stock bsed on the fundmentl ccounting vribles (ernings nd book vlue). In ddition, these models llow ny other informtion to intervene in predicting the firm s vlue. Howe ever the results of previous studies on these models show tht vlues clculted by these models re less thn the mrket vlue. The theory of the business life cycle uses generliztion of the developed concept of product life cycle in mrketing nd microeconomics. Products (goods or services) move in four stges: strt up, growth, mture nd stgnnt. Similrly, businesses cn lso be described in stges of the life cycle. Most reserchers clim tht businesses hve different chrcteristics t different stges of the life cycle which ffect the relevnt vlue or profitbility of ccounting performnce mesures. The life cycle pproch provides n nlysis of the frmework of economic content. Life cycle models of the firm hve entered finncil strtegy literture since 1960s. The min messge of the studies on the relevnce of performnce mesures is tht the vlue ssigned to performnce mesure by cpitl mrket prticipnts depends on the reltive importnce of this mesure in certin stge of the life cycle. Anthony nd Rmesh (1992) investigted the fct tht how the life cycle stges, s strtegic chrcteristics, my ffect the relevnce of ccounting dt. They stted tht sles growth nd cpitl expenditures in the erly stges of the life cycle re more importnt nd the mrket gives them more vlue. Gver nd Gver (1993) underlined tht vrition in investment opportunities will led to different finncing policies, dividend nd competition. They found tht growing firms use smller 643

4 leverge nd py few dividends. They lso use more shre-bsed compenstion bonus thn the firms which re in other life cycle stges. Blck (1998) suggests the uniform reduction of the relevnce of ernings nd csh flows in the stges of life cycle. Investigting the reltionship of ernings nd csh flows with the firm s vlue in different stges of their life cycle, he showed tht, in strt up nd decline stges, csh flows were more relevnt thn the ernings; while the reverse is true in the mture stge. By exmining the reltionship of sle growth nd profitbility with ernings nd csh flows, Mrtinez (2003) relized the non-liner effect of the life cycle on the relevnce of ernings nd csh flows. Jenkins et l. (2004) concluded tht when ernings re decomposed into their components, the effect of life cycle on the relevnce of ernings will be clerer nd stronger. Ahrony et l. (2006) exmined the explntory power of mesures bsed on csh flows nd those bsed on ccruls in defining the firm s vlue t different stges of the life cycle. In the growth stge, the explntory power of mesures bsed on csh flows ws higher but in the mture stge, the explntory power of mesures bsed on ccruls ws higher. Xu (2007), using regression nlysis, investigted the relevnce of risk fctors to the firm s life cycle. His reserch led to two importnt findings. First, risk fctors in different stges of life cycle re priced differently. Also, incrementl explntory power of risk fctors vries with the chnge of life cycle stges. While the Ohlson (1995) prediction nd vlution model relies on the firm s book vlue, ccounting ernings nd the ssumption tht "bnorml ernings re rndomized, blnced nd stbilized", however, ccording to the theory of life cycle, risk nd performnce indictors during the firm s life cycle re of vrious importnce (for exmple, see (Anthony nd Rmesh, 1992; Mrtinez, 2003; Xu, 2007)), nd their reltionship with the firm s vlue vries during different stges of the life cycle. The question which comes to mind is "whether considering the vrible of firm s life cycle cn improve Ohlson vlution model." Thus the min reserch hypotheses re formulted s follows: 1. Considering the firm s life cycle enhnces the bility to predict bnorml ernings of the Ohlson model Ohlson (1995); 2. Considering the firm s life cycle enhnces the bility to evlute the Ohlson model Ohlson (1995). 3. RESEARCH METHODOLOGY To test hypotheses in this study, we record the firm s plce in the life cycle stges s dummy vrible in the model. Since, ccording to previous literture, risk nd performnce indictors re of vrious importnce during the firm s life cycle nd tht their reltionship with the firm s vlue during different stges of life cycle is vrible (for exmple, see (Anthony nd Rmesh, 1992; Mrtinez, 2003; Xu, 2007)), the chrcteristics of the firm in mturity, re different with growth 644

5 nd decline stges, so D j, ws defined s dummy vrible with zero nd one vlues; in cse the t yer-firm belongs to growth nd decline stges, its vlue will be zero, nd if it belongs to the mturity stge, vlue of one will be ssigned to. Similr to Blck (1998), Jenkins et l. (2004) nd Kllunki nd Silvol (2008) used Anthony nd Rmesh (1992) vribles nd Prk nd Chen (2006) methodology to clssify firms life cycle in different stges of life cycle in this study. To distinguish firms in life cycle stges, they used the Anthony nd Rmesh (1992) vribles: SG it = [(SALE it / SALE it -1) -1] 100 DPR it = (DPS it / EPS it ) 100 (CEXPit/ VALUE it ) 100 =CE it AGE t = i- ES t SG= percent sles growth DPR= Annul dividend pyout divided by net income CE = Cpitl expenditure divided by totl vlue of the firm AGE= Age of the firm re computed s the difference between the current yer nd the erliest yer of incorportion for ech firm-yer. The four life cycle stge descriptors re clculted for ech firm-yer nd the four clssifiction vrible observtions for ech firm-yer re ssigned to ech industry quintile of the sme vrible nd they re given score s showed in figure 1. Tble-1. Life-Cycle Descriptors Industry Quintile Life-Cycle Descriptors AGE SG CE DP 80%-100% %-80% %-60% %-40% (2) 0%-20% (1) Note: If the sum of scores for AGE, SG, nd CE is low (i.e., smller thn 7.5), nd DP is t the lowest (second lowest) quintile, then one (two) is ssigned s the DP score for decline stge firm-yers. The composite score rnges from four to 20. Ech firm-yer is clssified into three life-cycle stges using the following procedure: 1. "GROWTH": If it's composite score is between 16 nd "MATURE": If it's composite score is between 9 nd "DECLINE": If it's composite score is between 4 nd 8. To test the first hypothesis of the study, bnorml ernings were djusted once by the Ohlson model nd once by other models tking into considertion the prediction life cycle; then, both the initil nd djusted models were compred with ech other by using the djusted r squred, Akike info criterion nd Schwrz criterion nd sum of squred residuls in order to determine the best model. The bnorml ernings vluted in the trditionl model were estimted s follows: X X t 1 11 t j, t 1 Where: X, : Abnorml ernings of yer t j t 11 : Persistence of bnorml ernings (0 < 11 <1) Ohlson ssumes tht sources of bnorml ernings re monopoly rents. Although the ltter 645

6 my be continued for period of time, mrket competition in the long run will mke them equivlent to the cost of cpitl. Thus, it is expected tht the w11 coefficient is between zero nd one. Considering the firm s life cycle stges nd being inspired by the djusted model of Giner nd Iniguez (2006b), the djustment of the Ohlson model is s follows: X X D j, t 1 11 j, t 11 j, t j, t j, t 1 j t X X, : Abnorml ernings of yer t 11: Persistence of bnorml ernings of firms on growth nd stgnnt stges : Persistence of bnorml ernings of firms on mture D, : Dummy vrible for firm j t time t ( D, =1 if firm is in mture stge nd 0 otherwise) j t j t To test the second hypothesis, vluting of the firm is done once by the Ohlson vlution model (Ohlson, 1995) nd the second time by the djusted model tking into ccount the life cycle. The vlution in the trditionl model ws estimted s follows: Where: bv : Book Vlue of firm of yer t t X, : Abnorml ernings of yer t j t 11 1 r 11 For vlution of firm vlue (V+) by djusted model we use sme trditionl model. The difference is tht in the djusted model, ws clculted by the following method: ( D j, t) 1 r ( D j, t ) V t bvt x j, t In both trditionl nd djusted models, equlity of the verge of estimted vlues ws verified by ech of the bove models (V, V + ) with mrket ctul prices (P) using the T-test; the bove equlity ws lso investigted by Wilcoxon signed-rnk test, nd then the men bsolute errors of prediction in both the initil nd djusted models ws compred to estblish the best vlution model. There were gret fluctutions over severl yers in Tehrn Stock Exchnge index. Two short nd long-term periods of 5 nd10yers, respectively, cn be solution to control the effect of these fluctutions. In ddition, due to mrket voltility over the lst few yers of the estimtion period nd especilly 2012 nd 2013, more rtionl pproch will be using dt from the erly yers of the short-term period. Therefore in this study, the test of hypotheses ws done by using pooled dt of the djusted popultion during the two estimtion periods of 5 yers ( ) nd 10 yers ( ). The sttisticl popultion of this reserch ws selected mong the firms listed in Tehrn Stock Exchnge. The popultion ws djusted with regrd to the following conditions nd ll firms who hd these conditions were studied. 646

7 Tble-2. Adjusting popultion procedure Description Qty Active Firms whose ccounting dt during the time intervl of reserch is ccessible 207 Deducted: firms whose monthly price dt in this time intervl hve not been ccessible 23 Deducted: firms whose fiscl yer not ending to 20th Mrch 56 Deducted: Insurnce nd Investment firms 18 Totl sum of qulified firms selected Accounting dt required for this study were collected from finncil sttements, dt on prices, nd mrket index using Rhvrd Novin 3 softwre, nd the dt relted to risk free rte ws collected from the rchive of the Centrl Bnk. 4. FINDINGS Descriptive sttistics for vribles re shown in Tble3 nd the yer-firms clssifiction sttistics in different stges of life cycle re s shown in Tble 5. Tble-3. Descriptive Sttistics Levin, Lin & Chu Unit Root Test ws utilized to exmine the relibility of the reserch vribles. As illustrted in Tble 4, the relibility of the vribles hs been pproved dt significnce level of 99 percent. Vribles Book vlue Abnorml Ernings Tble-4. Levin, Lin & Chu Unit Root Test Sttistic sig Yer Tble-5. Firms Clssifiction Sttistics Number of Firms On stges Stgnnt Mture Growth Totl Continue 647

8 Totl The First Hypothesis Test Results The results of fitting the two initil nd djusted regression models to test the first hypothesis of the study during both estimtion periods of 5 nd 10 yers re s described in Tble 6 nd Tble 7. The reserch results indicte the confirmtion of initil models efficiency in the prediction of bnorml ernings. This result conforms to the most reserches, i.e. McCre nd Nitsson (2001), Cllen nd Morel (2001) nd Khodddi nd Emmi (2010). Regression test results show the superiority of the djusted model to the initil one in terms of AR 2 index during both estimtion periods. The significnce of X d t vrible of the previous period during both estimtion periods t level of 1% indictes the significnce of the djustment done. To mke better comprison of both the initil nd djusted models for predicting bnorml ernings, Akike Informtion Criterion (AIC) nd Schwrz Criterion (SC) nd sum of squred residuls (SSR) were used. The results of this comprison re shown in Tble 8. As shown in the tble, Akike nd Schwrz criteri to estimte the djusted model re smller in both periods. In terms of criterion, the sum of squred residuls during both estimtion periods of the initil model is smller thn tht of the djusted model. In totl, evidence suggests the superiority of the djusted model in comprison with the initil model in predicting the bnorml ernings. So the first reserch hypothesis is confirmed. Tble-6. The results of first hypothesis in trditionl model The estimtion period w 11 Prob AR 2 DWS 5 yers yers Tble-7. The results of first hypothesis in djusted model The estimtion period w 11 Prob w 11 + w 11 Prob AR 2 DWS 5 yers yers Tble-8. Comprison of Reserch Models in Respect of First hypothesis *-indicting superior model 648

9 4.2. The Second Hypothesis Test Results According to the results obtined during the 5-yerestimtion period, vlues estimted by the initil model re good pproximtion of the ctul vlues. This result is support to the clim of Ohlson (1995), McCre nd Nitsson (2001),Cllen nd Morel (2001). In this estimtion period, vlues estimted by djusted model re good pproximtion of the ctul vlues too. The results listed in Tble9insure tht djustment of vlution model by considering the firm s life cycle will improve vlution power of the model during the 5-yer estimtion period. In terms of testing the equlity of mens, the significnce level in this period ws incresed from in the initil model to in the djusted model, nd this indictes the vlution power improved in both models. The equlity of mens of estimted nd ctul vlues t confidence level of 99% is so rejected. Improvement of vlution power in the djusted model is lso observble in terms of testing the equlity of mens; so tht the significnce level hs incresed from in the initil model to in the djusted model. As cn be seen in Tble9, the estimted vlues in the 10-yer estimtion period in both the initil nd djusted models significntly differ from the ctul vlues. In view of the shrp increse of stock vlue of the firms listed on the Tehrn Stock Exchnge during the yer 2012, especilly in 2013 (with regrd to the increse of the generl index from 25,400 t the beginning of 2012 to 38,040 t the beginning of 2013, nd to 78,968 t the end of this yer), the reson of difference between vlution models nd ctul vlues my be the price bubbles mde during these yers in the Tehrn Stock Exchnge but Confirm this clim to need to specific reserch in this re. The estimtion period 5 yers 10 yers Tble-9.The Results of mens nd medins Equlity Test T test(h0: μ V = μ P ) Wilcoxon signed rnk test(h0:medv=medp) djusted model trditionl model djusted model trditionl model T sttistic Sig T sttistic Sig Z sttistic Sig Z sttistic Sig The estimtion period Models Tble-10.Comprtive survey on the Vlution Power of Models Averge of Absolute vlution errors Totl number of observtions Observtions with V<P 5 yers trditionl model % 43% djusted model % 49% 10 yers trditionl model % 8% djusted model % 13% Observtions with V>P The comprison of vlution power of both models ws performed by compring the men bsolute errors of the vlution errors. According to Tble10, the vlues estimted by the djusted model in both estimtion periods hve fewer errors thn the initil model.. These results confirm the reserch second hypothesis. Similr to most domestic nd foreign reserch (e.g. (Dechow et l., 649

10 1999; Myers, 1999; Khodddi nd Emmi, 2010)), most of the estimted vlues in both the initil nd djusted models re less thn the ctul vlues. While the estimted vlues of the initil model re less thn mrket ctul vlues in the initil model during the 5-yer period t 57% of observtions nd during the 10-yer period t 92% of observtions, this proportion hs decresed in the djusted model to 51% nd 87%, respectively. 5. CONCLUSION Ohlson (1995) suggests tht the firm vlue is influenced by three fctors of the firm book vlue, residul ernings nd other informtion so tht we cn determine the fir vlue in cpitl mrket by specifying the inherent vlue. Since Ohlson prediction nd vlution model (Ohlson, 1995) relies on the firm book vlue, ccounting erning nd the ssumption tht "bnorml ernings re rndomized nd stbilized", nd lso ccording to the theory of life cycle which sserts tht risk nd performnce indictors re of vrious importnce during the firm s life cycle nd tht their reltionship with the firm s vlue vries during different stges of life cycle, this pper ws thus imed t reviewing the bility to improve Ohlson vlution model with regrd to the firm s life cycle vrible. To this end, the pooled dt of firms listed on the Tehrn Stock Exchnge from 2003 to 2013 were used. Additionlly, using Anthony nd Rmesh (1992) vribles nd Prk nd Chen (2006) methodology, ll yer-firms were divided into three life cycles, nd then the djusted model for predicting bnorml ernings ws compred with Ohlson initil model (Ohlson, 1995) for the firm s vlution during the estimtion periods of 5 nd 10 yers. The results indicte tht during both estimtion periods, the Ohlson djusted model, through considering life cycle, hd better performnce thn the initil model in predicting the bnorml ernings nd the firm s vlution. Results re supports to Life Cycle Theory. The life cycle theory of business entity ssumes tht the ltter presents different chrcteristics in different stges of the life cycle. The vlue of business entities is influenced by internl fctors, such s the choice of strtegy, finncil resources nd bility to mnge, nd externl fctors, such s competitive environment nd mcroeconomic fctors. The vlue ssigned to criterion by cpitl mrket prticipnts depends on the reltive importnce of this criterion in certin stge of life cycle. Stbility of sle, risk nd performnce indictors in mture stge is different with growth nd decline stges. Thus prediction of bnorml ernings, s sme s vlution, is different in mture firms with others. The reserch results will be pplicble for Investors nd Firms Mngers. It is expected tht the reserch results cn indicte model describing the investors stock theoretic vlue. The results help those mking better decisions. The firms stock price in finncil mrkets is focused by most mngers. Since this is one of their ssessment fctors in shreholder s viewpoint, chieving model segregting the stock unsubstntil price from the prices hving theoreticl bckup will provide better criterion for the ssessment mde by shreholders nd mngers defending of their opertion. 650

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