Measuring the Value Relevance of Stock Returns, Earnings, and Cash Flows Using the Gibbs Sampler

In this paper we develop a new approach for assessing the value relevance of accounting and financial variables. Since changes in firm value are unobservable, previous research in accounting and finance assessed the value relevance of accounting and financial variables, such as earnings and cash flows, using stock prices or returns as a value benchmark. However, a growing body of empirical evidence has shown that stock returns might not be an efficient summary of all value-relevant information. In this paper, we formulate a probability model that incorporates unobservable changes in firm value. After estimating the value changes using the Gibbs sampler, we measure the extent to which alternative value proxies are related to the estimates. Our results show that stock return is not an efficient measure of firm value or its change, although it is more value-relevant than accounting-based value measures, i.e., accounting earnings and cash flows. We further show that accounting earnings are a better measure of firm value or its change than cash flows, a finding consistent with previous research.