Growth Options and the Relation between Equity Value, Earnings, and Equity Book Value

Accounting research has taken a keen interest in the relation between equity value and the two summary accounting measures, namely, earnings and equity book value. In this study, we explore the importance of investment growth in influencing this relation. Using the model of Zhang (2000), we theoretically predict how growth affects the mapping of earnings and equity book value to equity value and empirically test the predictions. Our study shows the following results. First, investment growth increases the value impact of earnings, in terms of a steeper slope in the value-earnings relation, for high profitability firms (consistent with positive NPV growth), but mostly it has no significant effect on the slope for low profitability firms (zero NPV growth), with the effect becoming significantly negative for extreme low-profitability firms (negative NPV growth). Second, growth also exhibits varying effects across firms on the relation between equity value and equity book value. Given earnings, investment growth increases the slope of this relation for low profitability firms but reduces the slope for high profitability firms, causing equity value to be a non-monotonic function of equity book value over a wide profitability range. In contrast, holding profitability (instead of earnings) constant, equity value uniformly increases with book value, and growth increases the slope of this relation. Our study extends and modifies the existing views on how equity value is connected to accounting data.