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

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.