Review of Quantitative Finance and Accounting, 15 (2000): 21±35
# 2000 Kluwer Academic Publishers. Manufactured in The Netherlands.
Valuation Implications of Investment Opportunities and
JEFFERSON P. JONES
Auburn University, School of Accountancy, 301 Lowder Business Building, Auburn, AL 36849-5247
RICHARD M. MORTON
Florida State University, Department of Accounting, College of Business, Tallahassee, FL 32306-1042
THOMAS F. SCHAEFER
University of Notre Dame, Department of Accountancy, 102 College of Business Building, Notre Dame,
Abstract. This study investigates the value-relevance of accounting earnings in the presence of investment
(growth) opportunities after making two theoretical and methodological research design re®nements. First, we
test for the incremental effect of growth on ®rms' earnings response coef®cients after controlling for the extent of
transitory earnings under the assumption that the value-relevance of earnings with respect to growth should be
stronger when earnings are more permanent. Second, we perform comprehensive factor analysis using market-
based and accounting-based measures to construct a composite proxy for investment opportunities. We ®nd that
®rms' investment opportunities and the relative permanence of current earnings affect the value-relevance of
those earnings. Additionally, we ®nd that the interaction between permanent earnings and investment
opportunities produces an even stronger price response to earnings.
Key words: investment opportunities, earnings permanence
This study investigates the value-relevance of accounting earnings in the presence of
investment (growth) opportunities and earnings permanence. Previous research (Collins
and Kothari, 1989; Biddle and Seow, 1991; Harikumar and Harter, 1995) ®nds earnings'
value-relevance increases with various market-based proxies for ®rms' investment
opportunity sets. These results suggest that current earnings convey important information
to markets about future growth opportunities.
Our paper further addresses earnings' value-relevance in the presence of investment
opportunities by incorporating two major research design re®nements. First, we build
upon the intuition in Penman (1996) and the results in Freeman and Tse (1992) and Ali and
Zarowin (1992) by incorporating current earnings permanence in the speci®cation of the
earnings-return relation. This feature of our design is especially important because the
ability of current earnings to re¯ect the value of future growth opportunities critically
depends on the permanence of those earnings. Second, we use a composite proxy for
growth, following Gaver and Gaver (1993) and Baber et al. (1996), based on a factor