Stephen Penman

The Pricing of Earnings and Cash Flows and an Affirmation of Accrual Accounting

Coauthor(s): Nir Yehuda.

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Abstract:

Under accrual accounting, earnings add to shareholders' equity. Cash flow generated by a business has no effect on the book value of shareholders' equity but reduces the book value of net assets employed in business operations. In short, accrual accounting rules prescribe that earnings add to shareholder value, but cash flow is irrelevant to the valuation of equity. This paper documents that the stock market prices equity shares according to this prescription. Earnings are priced positively but, given earnings, a dollar more of free cash flow from a business—cash flow from operations minus cash investment—is, on average, associated with approximately a dollar less in the market value of the business and has no association with changes in the market value of the equity claim on the business. Furthermore, controlling for the cash investment component of free cash flow, cash flow from operations also reduces the market value of the business dollar-for-dollar and is unrelated to the changes in market value of the equity.

The PDF above is a preprint version of the article. The final version may be found at < http://dx.doi.org/10.1007/s11142-009-9109-4 >.

Source: Review of Accounting Studies
Exact Citation:
Penman, Stephen, and Nir Yehuda. "The Pricing of Earnings and Cash Flows and an Affirmation of Accrual Accounting." Review of Accounting Studies 14, no. 4 (December 2009): 453-479.
Volume: 14
Number: 4
Pages: 453-479
Date: 12 2009