Growth opportunities constitute an important part of firm value as investors would recognize, but how does investment growth figure in accounting-based valuation? What impact does such growth have on the relationships between equity value, earnings and equity book value?

Shengquan Hao, Qinglu Jin (former PhD students from HKUST) and Guochang Zhang examine these questions using theoretical and empirical research to show that the impact of growth varies across firms, depending on their profitability and other characteristics of business operations.

"When investors determine firm value based on reported accounting data, it is essential they consider how much the firm is expected to grow," they say. "Growth refers to increases (or decreases) in the amount of capital invested in business operations. Economic reasoning suggests that whether investment growth enhances value generation depends on profitability, defined as earnings in a period divided by the equity book value at the beginning of the period."

"Profitability represents a firm's ability to generate value from invested capital, thus indicating the desirability of increasing or reducing the scale of operations. It thus helps investors to infer the firm's course of operations going forward."

"Obviously investment growth undertaken by a profitable firm enhances investor value, whereas that by an unprofitable firm creates no value or even destroys value. Our analysis demonstrates how this basic notion about growth, profitability and value creation manifests in mapping accounting data to value."

Using a large sample of more than 100,000 firm-year observations from 1966-2003, the authors break down the various components to show how the impact of growth varies with the circumstances of the firm.

In terms of the relation between equity value and earnings given book value, growth tends to increase the value impact of earnings in high-profitability circumstances but have a smaller effect on low-profitability ones.

"When operations are so unprofitable that they are likely to be discontinued, equity value depends primarily on book value, with earnings being of little use in predicting value generation. As current earnings increase, and hence profitability increases given equity book value, the probabilities also increase that the firm will stay in business and its operations will grow. This raises expectations about future earnings," they say.

However, this result is reversed when considering growth and the relation between equity value and book value, given earnings. "Since firms with larger book values are less profitable (at a given earnings level), their growth options are less valuable than those of firms with smaller book values," they say.

In a third scenario - the effect of growth on the relation between equity value and book value given profitability - equity value is uniformly higher for firms with more capital invested in their operations. Growth will therefore increase the positive relation between these variables.

The authors also consider the role of accounting conservatism and past investment activities as regards growth. "Under a conservative depreciation policy, firms recognize more expense relative to unbiased depreciation in the initial years of an asset's life, but less expense in the latter years when the cumulative over-recognition gets unwound. Firms that have just experienced rapid increases in investments will state their earnings more conservatively than those experiencing a slow or negative increase in recent investments." The relation between equity value and earnings is affected by how conservatively earnings have been reported.

The findings help to provide a more complete view of the relation between equity value and accounting data, which should be of interest to investors, standard-setters and academic researchers.

"Our study provides a framework for thinking about how to perform financial analysis and valuation. In particular it explains that both prospective investment growth and past investment activities alter the way accounting data are mapped to value," the authors say.

"By demonstrating how the relation between equity value and earnings, and similarly that between equity value and book value, depends on investment growth, our results give a better understanding of the fundamental determinants of the price-to-earnings and price-to-book value multiples."