Operational Efficiency and the Value-Relevance of Earnings

This paper extends prior valuation literature by offering a new dimension to the economic analysis of differential earnings/price behavior. Specifically, a measure of firm performance, estimated using stochastic frontier methodology, is introduced to reexamine this relation. Results provide strong evidence that this efficiency measure explains some of the differences in value-relevance of earnings. The results are robust to functional forms, portfolio choices, timing differences, as well as to the inclusion of other explanatory variables such as risk, profitability, size and R&D. Finally, the possible link between efficiency and persistence is tested by evaluating the firms grouped based on their efficiency scores. The results indicate a significant relationship between the firms’ relative operational efficiency and earnings persistence.