Topic 4 Accounting information and value relevance

Learning Objectives
Understand the value relevance of accounting numbers or information;
Know how to measure the fundamental value of a firm;
Know what is meant by price divergence from the fundamental value of a firm; and
Know the potential causes of the price divergence

 Price divergence from fundamental value and the value relevance of accounting
information

 One criterion used to assess the usefulness of accounting information

The ability to reflect the fundamental value of a firm

 Fundamental value of a firm

 A fundamental value of a firm = intrinsic value of a firm = fair value of a firm
 Measuring the fundamental value of firm
For example, using the following models:
-Discounted cash flow model;
-Dividend discount model; and/or
-Comparable price multiples from firms in the same industry as sample firms such
as P/E (price earnings ratio) or P/S (price to sales ratio).、

 Market value of Total Assets (Enterprise Value)

Market Value of Equity (Market Capitalisation) =
the company’s shares on issue (SOI) x share price

 Market Value of Total Assets < Total Assets of the company in the balance sheet

 Market Value of Total Assets > Total Assets of the company in the balance sheet

 Valuing the company using Price Earnings (P/E) ratio

 Price Earnings (P/E) ratio = Share Price (SP)/Earnings per Share (EPS)

 EPS = Net Earnings or Net Profit After Tax/Total Shares on Issue

In the Australian context: Shares on Issue (SPI) = Total Shares Outstanding

 Scenario 1
Company A
Shares outstanding = 1,000,000.
Profit after tax = $1,000,000
Share price = $2

Company B
Shares outstanding = 10,000,000
Profit after tax = $2,000,000
Share price = $3

Assumptions: A and B operating in the same industry. Industry P/E ratio is 15 x. Other factors are
constant. Since the P/E ratio of company A is lower than company B., the share price of company
A is relatively cheaper than company B. The company A’s share has potential to increase from $2
to $15 (i.e., 15 x 1).

 Scenario 2
Company C
Shares outstanding = 1,000,000.
Profit after tax = $1,000,000
Share price = $4

Company D
Shares outstanding = 10,000,000
Profit after tax = $2,000,000
Share price = $3

Assumptions: C and D operating in the same industry. Industry P/E ratio is 15 x. Other factors are
constant. Since the P/E ratio of company C is lower than company D, the share price of company
C is relatively cheaper than company D. The company C’s share has the potential to increase
from $4 to $15 (i.e., 15 x 1).
 Scenario 3
Company E
Shares outstanding = 1,000,000.
Profit after tax = $1,000,000
Share price = $40

Company F
Shares outstanding = 10,000,000
Profit after tax = $2,000,000
Share price = $2

Assumptions: E and F operating in the same industry. Industry P/E ratio is 15 x. Other factors are
constant. Since the P/E ratio of company F is lower than company E., the share price of company
F is relatively cheaper than company E. The company F’s share has potential to increase from $2
to $3 (i.e., 15 x 0.2). On the other hand, the company E’s share is overvalued relative to the
average company in the same industry since its P/E ratio is higher than the industry P/E ratio.
Hence, the company E’s share has potential to decrease from $40 to $15 (i.e., 15 x 1).

 Value relevance of accounting numbers

 Prior studies (e.g., Lev and Zarowin 1999; Francis and Schipper 1999) that measure
value relevance by the R2 values of the regressions of stock market prices (or the
change in these prices) on accounting numbers generally document that these values
decline over time.

 Such findings have given rise to the claim that accounting information loses its value
relevance over time.

 Value relevance of accounting numbers

 An important assumption - efficient capital market in the sense that the market price
is a good proxy for fundamental value.

 Fung et al (2010) re-examine the value relevance of accounting information over time
by employing two empirical measures of fundamental value developed in prior studies
 Measuring the value relevance of accounting numbers
DepVar = α + β1Eps + β2BVps + ε

Fung et al. (2010) capture the R2s of the yearly cross-sectional

regressions of P or IV, on earnings per share and book value of equity
per share from 1984 to 2003, averaged for each five-year

where
DepVar = P or IV
P = closing stock price per share three months after the financial year
end;
IV = ex post intrinsic value per share based on a three-year horizon;
Eps = earnings per share; and
BVps = book value of equity per share.
ε = error term

 Using R2s of the regressions of P (closing share price) or IV (intrinsic value) on earnings
and book values of equity
 What does R2 or R-squared mean in the above context?
The closer its R-squared value is to one, the greater the ability of that model ( depicted in
previous slide) to predict a trend.

 Price divergence from fundamental value

Extract from Panel A of Table 2 (p. 838)

Period R2 (P) R2 (IV)
1984–1988 0.507 0.179
1989–1993 0.474 0.360
1994–1998 0.415 0.198
1999–2003 0.293 0.169
Panel A of Table 2 presents the R2s of the yearly cross-sectional regressions of P (closing share
price) on earnings and book values of equity of firms from 1984 to 2003, averaged for each five-
year period.

Extract from Panel B of Table 2 (p. 838)

Regression ƴ1 t-value
DV = P -0.012*** -2.69
DV = IV -0.005 -0.85

*, **, and *** represent significance at the 10 per cent, 5 per cent, and 1 per cent levels,
respectively, for the two-tailed tests.
  “Panel B of Table 2 shows that the R2s from regressions of share price on earnings
and book values of equity (P regression) significantly decline between 1984 and 2003
(coefficient = -0.012 and t-value = -2.69), consistent with the prior literature”.

 “However, the R2s of the regressions derived using the alternative value measure, IV
does not exhibit a clear declining trend (the coefficient for Trend becomes statistically
insignificant with t-value of -0.85). This shows that the evidence of the temporal
decline in the value relevance of accounting information that has been documented in
prior studies is sensitive to the firm-value measures employed”.

 Fung et al. (2010) find that stock prices (P) become a worsening measure of firms’
fundamental values over time.
 They conclude that there is no evidence to support that the value relevance of
accounting information declines over time using the alternative measure i.e., IV

 Food for Thought

Do you agree with Fung et al. (2010)?

-How do you compute the fundamental (intrinsic) value of a firm?

-Share price versus fundamental value
-Price divergence from fundamental value. Why?

You MUST read Fung et al. (2010) pages 849 to 851

 Price divergence from fundamental value

 Fung et al. (2010) investigate the factors that may contribute to the divergence of
stock prices from fundamental values.

 They posit that noise trading initially promotes such divergence (divergence-
promoting factor), and arbitrage risks & costs prevent stock prices from converging to
fundamental values once such mispricing or divergence exists (convergence-impeding
factors).

 Both the noise-trading measures and the measures of arbitrage risks and costs explain
the cross-sectional variations in the divergence of stock prices from fundamental
values.

Noise Trading and Arbitrage Risks

What Are Noise Trading & Arbitrage Risks?

 Summary
 Value relevance of accounting information
 Measuring the value relevance of accounting information
 Price divergence from fundamental value and the value relevance of accounting
information