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Expected Long‐Run Return on Equity in a Residual Income Valuation Model

Leonard C. Soffer (University of Illinois at Chicago, 601 S. Morgan (MC 006), Chicago, IL 60607)

Review of Accounting and Finance

ISSN: 1475-7702

Article publication date: 1 January 2003

510

Abstract

I show that the common residual income model assumption that return on equity approaches zero in the long run as competitive advantage dissipates is incorrect. This erroneous assumption comes from the common misinterpretation of the spread between return on equity and the cost of equity as a measure of economic profit. I also show that an unbiased accounting system (Feltham and Ohlson, 1995), which would make such an interpretation acceptable, is unlikely to exist in actual financial statements. Finally, I argue that because an accounting system can be deemed to be unbiased only if the firm's value is already known, the concept is of little practical use for actual valuation work.

Citation

Soffer, L.C. (2003), "Expected Long‐Run Return on Equity in a Residual Income Valuation Model", Review of Accounting and Finance, Vol. 2 No. 1, pp. 59-72. https://doi.org/10.1108/eb027001

Publisher

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MCB UP Ltd

Copyright © 2003, MCB UP Limited

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