The Value Relevance of Earnings and the Prediction of One-Year-Ahead Cash Flows

Abstract

In this paper we examine the validity of using one-year-ahead cash flows prediction tests as a substitute for the value relevance test of earnings. We show theoretically that the R2 of the cash flows prediction regression is contaminated by the presence of (1) noise in the cash flows and (2) spurious, i.e., value-unrelated, correlation between one-year-ahead cash flows and current earnings. We test if either of the above two factors contribute to the result of Kim and Kross (2005) that the ability of earnings to predict one-year-ahead cash flows has increased over the recent decades, in contrast to the evidence of decreasing value relevance of earnings. We find empirical evidence that both factors contributed to their result and conclude that the cash flows prediction test is a poor substitute for the value relevance test of earnings.

Keywords: value relevance of earnings, prediction of one-year-ahead cash flows

JEL Classification: G12, M41