Review of Quantitative Finance and Accounting, 22: 53–71, 2004
2004 Kluwer Academic Publishers. Manufactured in The Netherlands.
Change in Inventory and Firm Valuation
Department of Accountancy, Hong Kong Polytechnic University
Accounting and Finance Department, College of Business, Rowan University Tel.: (856) 256-4500, ext. 3031
Abstract. This study examines the effect of the informativeness of change in inventory on ﬁrm valuation. A ﬁrm’s
change in inventory is informative if its percentage change in cost of goods sold is positively and signiﬁcantly
associated with its lag one percentage of production added to inventory (a measure of change in inventory).
Sample ﬁrms are divided into two groups: ﬁrms with informative change in inventory, and other ﬁrms. Analyses
then are performed to examine the association between stock price and earnings. Results consistently show that
the association is higher for ﬁrms with informative change in inventory. Thus, knowledge on the informativeness
of change in inventory is useful for ﬁrm valuation.
Keywords: ﬁrm valuation, change in inventory, earnings, stock prices
JEL Classiﬁcation: M4
Fundamental analysis has been the primary approach used by security analysts for making
investment choices (Chugh and Meador, 1984). It assumes that the value of a stock can
be determined by careful examinations of fundamental value drivers. One of the drivers
is increase in inventory (Bernard and Noel, 1991; Lev and Thiagarajan, 1993; Jiambalvo,
Noreen and Shelvin, 1997; Ozanian and Fluke, 2001).
Bernard and Noel (1991) have investigated the predictive ability of inventory level on
sales and earnings. Their results indicate that increase in ﬁnished goods inventory has
no relation to future sales, but is negatively associated with future earnings.
overwhelming empirical evidence on the positive association between earnings and stock
price, increase in inventory most likely is also negatively associated with stock price.
Lev and Thiagarajan (1993) have searched and generated 12 signals for fundamental
analysis. One of the signals is increase in inventory, measured by percentage change in
inventory value minus percentage change in sales (referred to by Jiambalvo, Noreen and
Shelvin (1997) as PCIS).
Their result shows that increase in inventory is negatively asso-
ciated with 12 months excess stock returns, i.e., a result that is consistent with that implied
in Bernard and Noel (1991).
Jiambalvo, Noreen and Shelvin (1997) have also studied the association between cumu-
lative abnormal returns (CAR) over a 12 months window with the increase in inventory,