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Value relevance as defined in the researcher‟s model above, is the association between accounting numbers and security market values ( Share Price). That is the measure of the statistical association between financial statement information and stock market values (Share Price).
The key commonality in all the definitions given so far is that an accounting amount is deemed value relevant if it has a significant association with security market value (Share Price). The researcher‟s model states that value relevance is treated as proof of the quality and usefulness of accounting numbers.
2.2 Theoretical Framework
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study of past stock prices, nor even fundamental analysis, which describes the analysis of financial information such as company earnings, asset values, etc. would enable an investor in the long term to achieve returns greater than those that can be obtained by holding a randomly selected portfolio of individual stocks with comparable risk. So, it does not matter how much the investor informs him beforehand as the extent of the attainment of returns is due to chance and the only way to get higher returns seems to be a holding in riskier investments.
An efficient market can be defined as one where the current market price and the fair value resemble as all pertinent information is incorporated immediately. But even within the definition of efficient markets the occurrence of errors according to the valuation of the market price is permitted as long as they are random. As the deviations are random the chance of a stock being over- or undervalued should be equal and they should not correlate with certain variables like, e.g. a lower or higher PE ratio. This implies that no group of investors is able to consistently outperform the market over a long period of time by using any investment strategy as well keeping in mind that it is extremely unlikely that all markets are efficient to all investors. Instead, different tax rates and transaction costs impede investors from having all the same advantages.
However, the idea of market efficiency is that the market price is right. Thus, efficiency comes about as the result of competition. It always depends on the way of how investors draw a conclusion out of the competing behavior of all stockholders who invest into the market. All investors try to be the first to get the information that will affect security prices. By trading on this information, the price will quickly reflect the new information.
If an investor is about to find out some relevant news, e.g. increased sales figures, about a company, he would think about buying a stock. This action drives the price up, but if it rises too
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much it is possibly sold. Following this, information and competition are the essential principles guiding market efficiency. Moreover, if you think of an asset price being based on anticipating future conditions like future supply, demand, competition, etc., it needs to be kept in mind that these forecasts are made by using the information available which financial economists call information sets. The larger the information sets are the more accurate is the forecasted price.
Information is the key to success.
Furthermore, there is one common error which does not admit the perfection of markets. If markets are efficient, it does not mean that it is impossible to make any money. It only means that one will not earn more than it should be earned for assuming that level of risk. Therefore, beating the market means earning a profit above and beyond the required profit for that level of risk. It is extremely unlikely that all markets are efficient to all investors, but it is entirely possible that a particular market (e.g. the New York Stock Exchange) is efficient with respect to the average investor. It is possible that some markets are efficient while others are not, and that a market is efficient with respect to some investors and not to others. This is a direct consequence of different tax rates and transaction costs which confer advantages on some investors relative to others. Definitions of market efficiency are also linked up with assumptions about what information is available to investors and reflected in the price. For instance, a strict definition of market efficiency that assumes that all information, public as well as private, is reflected in market prices would imply that even investors with precise inside information will be unable to beat the market.
Malkiel (2003) notes that neither technical analysis, which is the study of past stock prices in an attempt to predict future prices, nor even fundamental analysis, which is the analysis of financial
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information such as company earnings, asset values, etc., help investors to select stocks.
However, most investors focus on companies rather than on stocks. Froidevaux, (2004) asserts that investors need to understand that a good company is not necessarily a good investment. The basis of efficient market hypothesis is that any variable change announcements should only have an impact on stock prices if they are unanticipated by capital market participants. Thus the individual investor lacking prior knowledge of any expected earnings or dividends announcements will react to this new information and affect share prices at the stock market.
Ball and Brown (1968) first assumed the Efficient Market Hypothesis in their study to calculate information value of accounting earnings. Though the adoption of Efficient Market Hypothesis was criticized on the ground of Modigliani & Miller propositions, which explicitly connect firm value with the expected returns (Modigliani & Miller, 1958). Modigliani –Miller propositions use expected return in estimating the return on share of stock , not actual return. Earnings, which is reported in financial statements, influence stock return only indirectly through its impact on expected earnings. The attribute of Modigliani & Miller propositions in Market Efficiency Hypothesis is a significant concern in Capital Market studies especially in emerging and developing economies where capital market are not well developed, but often have market inefficiency.
The question is whether market efficiency is necessary for Value relevance studies to produce reliable results. Aboody & Liu, (2002) suggested that the semi-strong market efficiency is necessary, if economic inferences are to be unbiased. Even if a market is not efficient, investors and their decisions can be significantly affected by accounting information. It has been argued
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that the semi-strong form of market hypothesis is relevant for accounting information because it is the primary source of public information through the issue of financial reporting (Hadi, 2006), The main ideals of the Efficient Market Hypothesis is that testing value relevance, requires a market where investors are free in making their decisions and where investors' decisions affect Share prices. Otherwise, even if accounting numbers are of highest quality, they will not have an impact on stock prices. Efficient Market Hypothesis portray that the stock market must be free from manipulation by the authorities, or people in power. This means that restrictions on trading must not be too strict or subject to authorities' discretion such as setting a narrow limit on daily price fluctuations and freezing trading. In an inefficient market, preferences of investors are not reflected in prices, so accounting information which influence these decisions are not relevant in determining share prices. It must also be noted that, the existence of an efficient market does not necessarily imply value relevance. Accounting information may still be of doubtful quality due to manipulation by reporting firms: accounting methods may not be well defined and so subject to manipulation; internal and external controls over Market activities may not be in existence. In such a case, rational investors will not base their decisions on accounting information.
This study is anchored on Market efficiency theory (Semi-strong), because the idea of market efficiency is that the market price is right and again in emerging countries like Nigeria the goal of Value relevance studies is only to determine if accounting information are at all relevant in determining share prices.