| Prior research on the earnings/price relationship focuses mainly on methodological and statistical modifications to deal with the weak results provided with the standard price/earnings model. Recent improvements in earnings’ explanatory power and the fit of the model have given researchers some guidance as to where to look for solutions. To date, the consensus is that the market reacts differently to earnings of different firms. In spite of strong evidence supporting this view, the literature has yet to provide an economic analysis for this differential earnings/price behavior. This study attempts to fill this void by providing a new measure, grounded in economic theory, to discriminate firms’ earnings in relation to their market values. The firm’s relative advantage in running its current operations profitably, and its ability to sustain this level of success in the future, is measured with efficiency scores, estimated using stochastic frontier methodology. These scores are then used to reexamine the price/earnings relation. The results provide strong evidence that the efficiency measure explains, at least partly, the differential value-relevance of earnings. The results are robust with respect to different functional forms, various portfolio choices, and dependent variables measured at different times. The relation of the efficiency scores to the other survival conditions of firms such as profitability and market power, as well as alternative explanations of this price/earnings relation established in the valuation literature, are then investigated. Although strongly associated with these concepts, efficiency scores provide additional information regarding firms’ future earnings ability. Finally, additional tests show that earnings of firms with high efficiency scores are more value-relevant, due to higher correlation of these firms’ current earnings to their future earnings. This study contributes to the existing literature in two ways. First, it enhances our understanding of the price/earning relation by offering an economic explanation as to why this relation varies across firms. Second, the study introduces the concept of efficiency, and its measurement technique of stochastic frontiers into the accounting literature. Further research can incorporate this technique into other areas of accounting research. |