The Pricing of Earnings and Cash Flows and an Affirmation of Accrual Accounting

Review of Accounting Studies, Vol. 14, No. 4, pp. 453-479

46 Pages Posted: 25 Aug 2011 Last revised: 19 Oct 2011

See all articles by Stephen H. Penman

Stephen H. Penman

Columbia Business School - Department of Accounting

Nir Yehuda

University of Texas at Dallas - Department of Accounting & Information Management

Multiple version iconThere are 2 versions of this paper

Date Written: December 2009

Abstract

Under accrual accounting, earnings add to shareholders’ equity. Cash flow generated by a business has no effect on the book value of shareholders’ equity but reduces the book value of net assets employed in business operations. In short, accrual accounting rules prescribe that earnings add to shareholder value, but cash flow is irrelevant to the valuation of equity. This paper documents that the stock market prices equity shares according to this prescription. Earnings are priced positively but, given earnings, a dollar more of free cash flow from a business ─ cash flow from operations minus cash investment ─ is, on average, associated with approximately a dollar less in the market value of the business and has no association with changes in the market value of the equity claim on the business. Furthermore, controlling for the cash investment component of free cash flow, cash flow from operations also reduces the market value of the business dollar-for-dollar and is unrelated to the changes in market value of the equity.

Keywords: Accruals, Cash Flow, Accrual Accounting

JEL Classification: G14, M40, M41

Suggested Citation

Penman, Stephen H. and Yehuda, Nir, The Pricing of Earnings and Cash Flows and an Affirmation of Accrual Accounting (December 2009). Review of Accounting Studies, Vol. 14, No. 4, pp. 453-479. Available at SSRN: https://ssrn.com/abstract=1916331

Stephen H. Penman (Contact Author)

Columbia Business School - Department of Accounting ( email )

3022 Broadway
New York, NY 10027
United States
212-854-9151 (Phone)
212-316-9219 (Fax)

Nir Yehuda

University of Texas at Dallas - Department of Accounting & Information Management ( email )

2601 North Floyd Road
Richardson, TX 75083-0688
United States

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