Equities

The Persistence and Pricing of the Cash Component of Earnings

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The Persistence and Pricing of the Cash Component of Earnings

In this paper, we provide a detailed investigation of the persistence and pricing of the cash component of earnings. Our investigation distinguishes between three different categories of the use of cash: it can (i) be retained by the firm in its cash balance, (ii) be distributed to debtholders or (iii) be distributed to equity investors.

We find that the higher persistence of the cash component of earnings is entirely attributable to cash distributed to equity investors.

We also show that stock prices act as if investors anticipate the persistence of earnings distributed to debt and equity holders, but overestimate the persistence of earnings retained on the balance sheet. This suggests investors are likely to be overly optimistic about the investment opportunities of firms that are building their asset bases and retaining capital.

Earlier research suggested that the lower persistence of accruals arises because accruals are more subjective and hence more susceptible to measurement error. 1 1 Close Sloan, R. G., 1996. Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review 71, 289-315. An alternative interpretation is that accruals measure changes in invested capital and changes in invested capital are associated with diminishing marginal returns to new investment (and related overinvestment).

Note that this alternative interpretation does not contradict the earlier conclusion; both probably co-exist. Indeed, since GAAP accounting requires the immediate impairment of unprofitable investments, one could argue that the two interpretations are indistinguishable.

Our results have implications for analysts and investment bankers who use discounted cash flow to determine intrinsic values of public companies. A common practice is to (incorrectly) assume that the cash balance can be immediately paid out, thus inflating intrinsic values.

Published in

Journal of Accounting Research

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