The Fundamental Relation Between Firm Market and Accounting Values Is a Multiplicative Power Law

Abstract

We provide a solution that may offer closure to the question of how to best measure the empirical relation between stock market values and accounting numbers. The models that dominate studies of the relevance of accounting numbers produce coefficient estimates that are hard to interpret and exhibit high volatility. We present a theory that demonstrates a multiplicative power law describes the long-run relation between market values and ac-counting values. Consequently, the correct forms for estimating the most basic market-accounting relations are log-linear and the relevant response coefficients are elasticities. We estimate these elasticities for the years 1971-2016, comparing them to response coefficients of traditional, additive-linear models that relate market and accounting values. Our results demonstrate the superiority of using elasticities to measure the empirical relation between market values and accounting numbers.

Keywords: Fundamentals, Log-Linear Models, Value Relevance.

JEL Classification: C10, C46, M41