The Contribution of Fundamental Analysis in the Presence of Inflation and a Currency Devaluation

Abstract

The primary purpose of this paper is to investigate the value relevance of fundamental analysis under the types of economic conditions that commonly occur in developing countries. By considering changes in key components of operating performance (e.g., changes in gross margin or changes in expenses relative to sales), fundamental analysis has the potential to capture more completely the value relevance of accounting information. Despite this potential, the literature on the value relevance of fundamental analysis is very limited in comparison to the vast literature investigating the value relevance of the two key summary measures provided in financial statements: earnings and book value. Furthermore, little is known about the advantage, if any, of fundamental analysis over summary measures in economic settings that are significantly different from that of the United States. This paper uses Mexico as a setting in which to explore further the value relevance of fundamental analysis. Mexico differs from the U.S. in two important respects that may influence the incremental value of fundamental analysis: First, during the 1990s, Mexican businesses had to cope with a rapidly changing business climate. Second, Mexican companies have reported replacement-cost, price-level-adjusted (RCPLA) information in the primary financial statements since 1984. Under RCPLA accounting, all balances reported on the financial statements, including the prior year amounts, are rolled forward into purchasing power at the end of the most recent period. We find that fundamental analysis has incremental value relevance in comparison to earnings. Of particular interest, fundamental signals based on line-item components of the 1994 financial statements, but not earnings, provided value relevant information about the effects of the December 1994 devaluation on the market's expectation about changes in future cash flows. This study makes a direct contribution to understanding the value relevance of fundamental analysis and accounting for changing prices. In addition, the study adds to a recent literature investigating the interaction between economic change and the value relevance of financial statement information.