The Persistence and Pricing of the Cash Component of Earnings
47 Pages Posted: 3 Jan 2005
Date Written: April 2006
Prior research shows that the cash component of earnings is more persistent than the accrual component of earnings. We investigate whether the persistence of the cash component is influenced by management's decision to retain or distribute cash flows. We find that when firms retain the cash flows, the cash component has low persistence almost identical to that of accruals. Only when the cash flows are distributed to equity holders does the cash component have high persistence. We investigate whether investors understand the differential implications of each use of cash flows for future earnings. Inconsistent with a naïve fixation on earnings, we find that investors correctly price cash flows relating to equity and debt distributions. However, we find that retained cash flows are mispriced in a similar manner to accruals. Our results are consistent with a combination of investors misunderstanding diminishing marginal returns to new investments and/or over-investment. Our results also suggest that discounted free cash flows valuation models should explicitly forecast retained cash flows.
Keywords: Accruals, free cash flow, capital markets, earnings persistence
JEL Classification: G12, G14, G35, M41, M43
Suggested Citation: Suggested Citation