The Effect of Market Inefficiency on the Value Relevance of Earnings

Abstract

This study investigates the effect of market inefficiency on the value relevance of earnings. Many prior studies challenge the efficiency of the stock market, an assumption the value relevance studies build on. With evidence of market inefficiency, it becomes important to understand how the extent of market inefficiency affects the results presented in value-relevance studies. Using the speed of a stock’s price response to news as the measure of the degree of market inefficiency, we investigate the effect of market inefficiency on the relation between annual returns and contemporaneous annual earnings, as well as future earnings. We document that the informativeness of future earnings and current earnings is negatively related to the level of market inefficiency. These results suggest that when market efficiency improves, contemporaneous and future earnings of firms become more informative.

Keywords: Market Efficiency, Value Relevance of Earnings

JEL Classification: G14, M41