An Examination of the Relative Abilities of Earnings and Cash Flows to Explain Returns and Market Values

38 Pages Posted: 30 Jan 2018

See all articles by Paul Hribar

Paul Hribar

University of Iowa - Henry B. Tippie College of Business

Sam Melessa

University of Iowa - Department of Accounting

Richard Mergenthaler

The University of Arizona - Eller College of Management

R. Christopher Small

University of Toronto - Rotman School of Management

Date Written: January 1, 2018

Abstract

We examine why, as a summary statistic, earnings is better than cash flows at explaining contemporaneous returns despite being a worse predictor of future operating cash flows. Several studies compare the ability of earnings and operating cash flows to predict valuation-related outcome variables including, stock returns, market values, and future operating cash flows. Although past results are mixed, recent studies suggest earnings are a better summary predictor of returns while operating cash flows better predict future operating cash flows. In this study, we replicate these two findings using a constant sample and consistent variable definitions, and examine several possible explanations for why earnings outperform cash flows in explaining contemporaneous returns and market values. Our results suggest that earnings outperform cash flows in explaining variation in both future free cash flows and discount rates. When directly comparing the two, we find that earnings' superior ability to explain variation in discount rates is more responsible than its ability to explain variation in future free cash flows. We provide evidence that the mechanism by which earnings explain more variation in discount rates than cash flows is accounting conservatism or timely loss recognition.

Keywords: earnings, future cash flows, discount rates, timely loss recognition

JEL Classification: M41

Suggested Citation

Hribar, Paul and Melessa, Sam and Mergenthaler, Richard Dean and Small, R. Christopher, An Examination of the Relative Abilities of Earnings and Cash Flows to Explain Returns and Market Values (January 1, 2018). Rotman School of Management Working Paper No. 3107145. Available at SSRN: https://ssrn.com/abstract=3107145 or http://dx.doi.org/10.2139/ssrn.3107145

Paul Hribar (Contact Author)

University of Iowa - Henry B. Tippie College of Business ( email )

Dept. of Accounting
Iowa City, IA 52242-1000
United States
319-335-1008 (Phone)

Sam Melessa

University of Iowa - Department of Accounting ( email )

108 Pappajohn Business Building
Iowa City, IA 52242-1000
United States

Richard Dean Mergenthaler

The University of Arizona - Eller College of Management ( email )

Tucson, AZ 85721
United States
520-621-2929 (Phone)
520-621-3742 (Fax)

HOME PAGE: http://https://accounting.eller.arizona.edu/people/rick-mergenthaler

R. Christopher Small

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6
Canada

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