The Valuation‐relevance of Earnings and Cash Flows: an International Perspective

Abstract

We investigate which variable, earnings or cash flows, provides greater information for equity valuation within the United States, the United Kingdom, Canada, Germany, and Japan. We regress returns on earnings and cash flow metrics. We generally find earnings developed in three Anglo‐Saxon countries—where capital is traditionally raised in public markets and reporting rules are unencumbered by taxation requirements—to have greater explanatory power for stock returns than cash flow metrics. Conversely, in two non‐Anglo‐Saxon countries—where capital is traditionally raised from private sources—earnings are generally not superior to cash flows for equity valuation, except in Japan, non‐consolidated sample. While sensitivity analyses generally support the conclusions of our primary tests, in some of the additional analyses, earnings were superior to cash flows for samples from all countries. As expected, in all countries earnings have incremental information content over cash flows in explaining returns. Collectively, our findings provide two contributions. First, we generalize the findings of prior US research by showing that earnings are more important than cash flows for equity valuation in other Anglo‐Saxon countries. Second and more importantly, our findings demonstrate that the superiority of earnings over cash flows is not universal. Rather, it depends on the national reporting regime and attendant institutional factors.