The Persistence and Pricing of the Cash Component of Earnings

47 Pages Posted: 3 Jan 2005

See all articles by Patricia M. Dechow

Patricia M. Dechow

University of Southern California - Leventhal School of Accounting; University of California, Berkeley - Accounting Group

Scott A. Richardson

AQR Capital Management, LLC; London Business School

Richard G. Sloan

University of Southern California - Leventhal School of Accounting

Date Written: April 2006

Abstract

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

Dechow, Patricia M. and Richardson, Scott Anthony and Sloan, Richard G., The Persistence and Pricing of the Cash Component of Earnings (April 2006). 20th Australasian Finance & Banking Conference 2007 Paper. Available at SSRN: https://ssrn.com/abstract=638622 or http://dx.doi.org/10.2139/ssrn.638622

Patricia M. Dechow

University of Southern California - Leventhal School of Accounting ( email )

Los Angeles, CA 90089-0441
United States

University of California, Berkeley - Accounting Group ( email )

Haas School of Business
Berkeley, CA 94720
United States

Scott Anthony Richardson (Contact Author)

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Richard G. Sloan

University of Southern California - Leventhal School of Accounting ( email )

Los Angeles, CA 90089-0441
United States

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