Opportunities Knocking: Residual Income Valuation of an Adaptive Firm

Abstract

Maintaining a competitive edge requires a firm to replace deteriorating business lines with new projects. Accordingly, part of a firm's value resides in its ability to exploit new opportunities. This paper incorporates adaptation into Ohlson's residual income valuation framework and obtains an adaptation-adjusted valuation formula. Although parsimoniously cast, the model makes two predictions that are consistent with phenomena reported in the empirical literature: earnings convexity and complementarity. Moreover, the Appendix introduces an Equivalence Theorem relating Modigliani-Miller dividend invariance, complementarity, and convexity.