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

Abstract

Under the rules of accrual accounting, free cash flow from operations reduces the book value of operations but does not affect the book value of shareholders' equity. Earnings from operations, on the other hand, increase both the book value of operations and shareholders' equity. In effect, accrual accounting rules prescribe that earnings add to shareholder value but free cash flow is irrelevant to the valuation of equity. This paper documents that the stock market prices equity shares according to this prescription, and thus provides a validation of accrual accounting. While earnings from operations are priced positively in the market, free cash flow is priced negatively; indeed, a dollar more of free cash flow is associated with approximately a dollar less in the market value of the firm. Controlling for the cash investment component of free cash flow, "cash flow from operations" also reduces the market value of the firm dollar-for-dollar. Further, annual equity returns are unrelated to the free cash flow that firms generate.

Keywords: Equity pricing, accruals, cash flows

JEL Classification: M41, G34, G12