Residual income and stock performance: evidence from the Johannesburg stock exchange

Abstract

There is surprisingly little evidence provided by accounting research on whether the Residual Income (RI) model can give us more information on a stock’s systematic risk. This report addresses two questions pertaining to the use of the RI model: (1) Does RI have any relationship with a stock’s systematic risk? (2) Is the RI measure preferred by investors, in measuring stock returns as opposed to Cash Flow from Operations (CFO)? Using a cross-section sample of non-financial firms in the South African economy over a duration of six years and after applying panel data analysis this research finds that indeed there is a significant and negative relationship between RI and systematic risk. The report finds inconclusive evidence to suggest that the RI model is preferred by market participants in modelling stock returns over a firm’s CFO, when an annual data set is used. However, we do find that the RI model is preferred, over CFOs, by the capital markets when it comes to measuring of stock returns when semi-annual data is utilized. Although not a direct objective of this research, it is found that the stock price continues to play a significant role in the determination of stock returns by investors. Furthermore, the report stresses the importance of firms to put more emphasis on long-term profitability, when they use the RI model to measure management performance, in order to fully rip its benefits post implementation.