The valuation effect of investor behavior on the relevance of financial information

In response to growing concerns about the usefulness of current financial reporting, several studies have investigated changes in the value relevance of financial information during the last few decades. In addition to lacking a consensus on whether there has been a decline in value relevance, a major concern over this literature relates to the appropriateness of the conventional method for measuring relevance based on the market price-financial variable association. Motivated by growing evidence in the behavioral finance literature that market prices deviate from their underlying fundamental values, this study argues, and demonstrates empirically, that the increasing disconnect between market prices and financial information, and consequently the documented decline in value relevance, is the outcome of two effects, not one effect as previously interpreted. First is the accounting measurement effect , reflecting a failure in current financial reporting to (fully) capture the underlying economic value of the firm, resulting in a genuine decline in value relevance. Second is the investor behavior effect caused by growing influence of non-fundamental factors in investor pricing decisions, which results in an artificial decline in value relevance. These insights are based on the implications of the residual income valuation model which is employed to estimate proxies for these two effects.; Results show that, based on the conventional method, there has been a decline in the value relevance of financial information during the period between 1980 and 2001. As hypothesized, the documented decline in value relevance is not solely the outcome of financial reporting becoming less relevant (the accounting measurement effect), but is similarly caused by growing speculation in investor pricing decisions as evident in the increasing extent of non-fundamental values in market prices (the investor behavior effect). Results are robust to various measurement specifications and research design issues. An additional analysis of value relevance based on the association between financial variables and estimated fundamental values indicates no decline in financial information value relevance during this period and shows that the documented decline in value relevance is driven mostly by increasing investor speculation that is not attributable to changes in fundamental values.