Market efficiency and the capacity of stock prices to track a firm's future profitability

Abstract This study assesses the link between market efficiency proxies and the capacity of stock prices to anticipate a firm's future economic performance. The analysis, which covers firms from 31 countries in the period 1990–2019, reveals a strong association between the average score of market efficiency proxies and the sensitivity of current stock returns (“normalized” prices) to future profitability. These results are robust to several sensitivity tests, including different definitions of the profitability measure (earnings, cash flows, firm-specific earnings and ROA). Further analysis unveils heterogeneity in the association between popular proxies of market efficiency and the sensitivity of current stock returns (“normalized” prices) to future profitability. The signal-to-noise ratio and the partial adjustment coefficient are the market efficiency measures that display a higher association with the capacity of stock prices to track future profitability. Critically, other indicators display a weak association after controlling the effect of liquidity or the information environment.