The information content of historical cost earnings versus current value earnings
Kieso, Douglas W.
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This study analyzed the market's reaction of Price/ Earnings (P/E) ratios of 38 companies over the five-year period from 1979 to 1983 with earnings determined by historical cost earnings and then with current value earnings. The current value earnings were determined from the supplementary information as required by Financial Accounting Standards Board Statement No. 33, Financial Reporting and Changing Prices. The study employed the efficient market hypothesis and analyzed the differences between estimated risk- adjusted rates of return and actual returns of common stock and was designed to answer the following questions: 1. Is there information content in the P/E ratio when earnings are based on historical cost earnings? 2. Is there information content in the P/E ratio when earnings are based on current value earnings? 3. Does the information content in the P/E ratio with historical cost earnings have more or less value than the information content in the P/E ratio with current value earnings? According to the findings of this study, there was significant information content in the P/E ratio when earnings were based on historical cost earnings; low P/E stocks consistently outperformed middle and high P/E stocks. This would indicate an inefficiency in the market and/or a misspecification of the market model employed in the study. The results also indicated that there was little, if any, information content in the P/E ratio when earnings were based on current value earnings. Therefore, it was concluded that historical cost earnings were of more value than current value earnings in the context of the P/E model.