The Relation between Stock Prices and Accounting Information

The functional relation between expected stock prices and accounting information is analyzed through the theory of inverse probability. The approach models the mean of the posterior distribution for price, given the information that the accounting process provides. The implications of alternative assumptions about accounting measurement error and the unconditional price distribution are discussed. Our most refined model is consistent with recent empirical evidence showing convexity in the relationship between price and accounting information. Empirical tests, while exploratory, provide further evidence of a nonlinear relation between stock price and accounting measures of earnings and book value.