An inflation specification of an accounting-based valuation model with empirical evidence from Mexican accounting disclosures.

Abstract

This research investigates the role of financial statement data in valuing the firm in an inflationary economy. Specifically, the study investigates the relation between general price level-adjusted and current cost accounting disclosures in Mexican financial statements and the market value of publicly traded firms. The evidence suggests that these disclosures are relevant to the Mexican stock market over a wide range of inflation rates. The Mexican market is chosen as the focus of the investigation because of Mexico's inflationary economy, its growing significance in U.S. international transactions, and because of the importance of the U.S. to Mexico's fragile economy. The issue of firm valuation in an inflationary economy is addressed here by using the framework introduced in the accounting-based valuation literature. Ohlson (1995) reexamines the accounting-based valuation model that appeared earlier in Edwards and Bell (1961). The Ohlson study, and subsequent empirical studies which draw upon Ohlson's accounting-based valuation theory, do not address the issue of accounting for changing prices as suggested by Edwards and Bell. The effects on asset valuation of accounting for changing prices are investigated here using a modification of the accounting-based valuation model to relate basic accounting data and other financial statement information with firm value. The additional information employed here consists of constant peso and current cost disclosures found in Mexican financial statements. The volatile macroeconomic environment in Mexico provides an ideal setting for testing the importance of accounting data that have been adjusted for price changes. This study exploits that environment by estimating an accounting-based valuation model on a sample of publicly traded Mexican companies during a four-year period when inflation rates in Mexico were initially extremely high (130%), and later relatively low (20%). The results indicate that accounting data adjusted for changing prices explain a significant portion of the cross-sectional variation in the market value of equity and price/book ratios of Mexican firms. The results also indicate that the significant explanatory power of holding gains does not weaken with decreases in the general level of inflation. These results suggest that current cost and constant peso disclosures are relevant for determining firm value over a wide range of inflation rates.