The Implications of Cash Flows for Future Earnings and Stock Returns Within Profit and Loss Firms

Abstract

The current study examines the association of cash subcomponents of earnings with future profitability and stock returns, conditional on the sign of current profitability. The empirical findings, based on a sample of UK listed firms for the period 1989-2013, indicate that, the higher persistence of the cash component of earnings is entirely attributable to cash distributions to equity holders and that investors fail to anticipate this higher persistence, leading to significant mispricing. Cash distributions to equity holders appear to have a positive relation with future returns. Furthermore, we show that the positive effect of the cash subcomponent related to equity financing activities on future earnings and stock price performance, is highly attenuated across profit firms, and becomes more severe across loss firms. Overall, our findings lend support to the earnings fixation hypothesis in explaining the pricing implications of the cash component of earnings on future stock returns.

Keywords: earnings, cash flows, persistence, valuation, U.K.

JEL Classification: G1, M4