Theoretical Role of the Most Recent Prior Period’s Equity Price in Value Relevance Studies

Abstract

This paper uses the Ohlson (1995) model and other related literature to theoretically demonstrate that the empirical specification of value relevance models with current or next period’s equity price as the dependent variable can be vastly improved when they utilize the most recent prior period’s equity price as an additional explanatory variable. The explanation further indicates that value relevance studies that use the Ohlson (1995) model should employ change in price or else returns, not the price level, as the dependent variable. These improvements to the empirical specification are shown to be important when past share price is highly correlated with important information that affects future earnings. This study reformulates the Ohlson (1995) value relevance model to demonstrate how it accommodates the most recent prior period equity price as an additional explanatory variable and also demonstrates how the earnings-based value relevance regression model equations can be used to improve the empirical specification for investigating the value relevance of an accounting variable.