Is stock price a good measure for assessing value-relevance of earnings? An empirical test

• Published in: Review of managerial science Vol. 1; no. 1; pp. 3 - 45
• Main Authors: Dontoh, Alex, Radhakrishnan, Suresh, Ronen, Joshua
• Format: Journal Article
• Language: English
• Published: Heidelberg Springer Nature B.V 01-04-2007
• Subjects: Accounting; Economic models; Financial statements; Prices; Stock prices; Studies
• ISSN: 1863-6683; 1863-6691
• DOI: 10.1007/s11846-007-0002-x

Recently, a growing body of literature has created a widespread impression that financial statements have lost their value-relevance because of a shift from traditional capital-intensive economy into a high technology, service-oriented economy. In particular, the claim is that financial statements are less relevant in assessing the fundamental value of high technology, service-oriented firms/activities, which are by nature knowledge-intensive. These conclusions are based on past studies that examine the association between accounting numbers (i.e., earnings and book values) and stock prices and show that, in general, the association between accounting information and stock prices has been declining, over time. These findings have been interpreted to be the result of a decline in value relevance of accounting. We examine the predictive content of stock prices and accounting information, as against the contemporaneous association between accounting information and stock prices. We find that while both the predictive content of earnings and prices declined over time, the predictive content of price signals declined by even more. Our analysis suggests that the declining association could be the consequence of increased noise in stock prices over time resulting from increases in trading volume driven by non-information based trades, and not just a decline in the predictive content of earnings. More importantly, this conclusion is consistent with the insights of the noisy rational expectations equilibrium framework analysis, i.e. that increased noise has caused the predictive content of prices to degrade over time. Overall, our evidence suggests that stock prices may not be an appropriate benchmark for gauging the information content of accounting earnings.[PUBLICATION ABSTRACT]