Non-linear equity valuation

We incorporate a real option component into the Ohlson (1995) equity valuation model and then use this augmented model to make assessments about the form and nature of the systematic biases that are likely to arise when empirical work is based on linear models of the relationship between the market value of equity and its determining variables. We also demonstrate how one can expand equity valuation models in terms of an infinite series of ‘orthogonal’ polynomials and thereby determine the relative contribution which the linear and non‐linear components of the relationship between equity value and its determining variables make to overall equity value. This procedure shows that non‐linearities in equity valuation can be large and significant, particularly for firms with low earnings‐to‐book ratios or where the undeflated book value of equity is comparatively small. Moreover, it is highly unlikely the simple linear models that characterise this area of accounting research can form the basis of meaningful statistical tests of the relationship between equity value and its determining variables.