A Study On The Relative Importance Of Earnings And Cash Flows In Equity Valuation

A fundamental question in accounting is the relative ability of accrual-based earnings and cash flows to predict a firm's ability to generate future cash flow. However, despite extensive research, the relative superiority of cash flows versus earnings as summary predictors of future cash flows remains largely unresolved. We reexamine this important problem by comparing the relative ability of earnings and cash flows in explaining ex post intrinsic value of equity. We determine ex post intrinsic value of equity by discounting future dividends over a three-year horizon and market price at the end of the horizon by industry cost of equity. The advantage of the ex post intrinsic value measure over stock returns is that it is not contaminated by the stock market's fixation on reported earnings. Also, unlike finite horizon future operating cash flows, ex post intrinsic values better reflect the magnitude, timing, and uncertainty of investers' future cash flows. Our results suggest that accrual-based earnings dominate operating cash flows as a summary indicator of ex post intrinsic value, and the importance of both earnings and cash flows in equity valuation had been raised year by year.