The Information Content of Cash Flow Figures

Abstract

This paper investigates the link between earnings and share prices for a sample of UK companies for the years 1961 to 1977. Three measures of earnings were used: the traditional historical cost accounting return and two which were closer to cash flow measures. The strength of the link between earnings and cumulative abnormal returns was investigated relative to the level of inflation. The results indicate that, while there is substantial information content in the traditional historical cost rate of return, there is very little information conveyed by the measure closest to pure cash flow. No support was therefore found for the use of cash flow based reports. Evidence was found showing substantial changes in the nature of the relationship between accounting and stock returns, but this could not be explained by the effects of inflation. This paper complements the study by Board, Day & Walker (1989) which examined the link between inflation and company profit for a large sample of US companies. The paper examines the link between earnings and share prices for a sample of UK companies, making use of three measures of earnings (two of which are closer to cash flow based measures than historical cost earnings). The strength of this link relative to the rate of inflation is also considered. Section I contains some discussion of the hypotheses under examination, sections I1 and I11 contain discussion of the techniques and sample, and sections IV to VII discuss the results of the tests. Section VIII contains some concluding remarks. I. Theoretical frameworkIt now seems generally agreed that, although accounting numbers are not the only source of information about companies' prospects, accounting earnings do provide information to the stock market which is used in the setting of prices. A crude rationale for this belief might be that increased profits indicate an increased likelihood of that company being in a good trading position. A more sophisticated view, following from the implications of the efficient market hypothesis, which highlights the linkages between share prices and earnings, is given below.Rational shareholders are assumed to be concerned only with their eventual wealth, which is derived from gains made from dividend payments *The authors are members of the Department of Accounting and Finance, London School of Economics and Political Science. They are most grateful to the referees of this paper, whose suggestions have resulted in a much improved paper. and capital gains. Thus the price of a share should reflect the present value of a stream of expected future dividends. Changes in expectations about this stream will cause the price to change, enabling shareholders to make gains or losses on sale. As the following equation shows, the dividend stream is based on the pattern of expected future cash flows, and so we would expect information which is used to form expectations about the future pattern of cash flows to be useful. P, = 1 E(DJ(1 + r)[ = 1 E(CFJ(1 + r)' m m 1 = O 1 = O where D, represents the divide...

The Relationship between Earnings and Stock Returns: Empirical Evidence from the Greek Capital Market

“…They concluded that both specifications are important in explaining stock returns but the differenced model yield higher ERC's compared to the return model. This finding agrees with studies by Martikainen et.al (1991), Board and Day (1989), Alford et.al (1993) and Harris et.al (1994).…”

The Incremental Information Content of the Cash Flow Statement: An Australian Empirical Investigation

“…The focus on cash flows from operations may be the serious limitation of this study. Simons (1992); Charitou and Vafeas (1998);and Board and Day (1989) provided similar conclusion to the study of Cheng, Liu and Schaefer (1997).…”

“…However, Ali and Pope (1995) doubted the validity of the three performance measures employed by Board and Day (1989). Ali and Pope extended Board and Day's study by incorporating some recent innovations in the specifications of earnings-returns model.…”

“…For example, it is utilised in debt covenants and by investors and creditors for the purpose of their investing and financing decisions. Also it is well documented that earnings has information content (e.g: Ball and Brown, 1968;Board and Day, 1989;and Charitou and Ketz, 1990).…”

The implications of financial performance on stock exchange indicators of listed companies: empirical evidence for the Romanian capital market

“…Others are saying that there is a lower correspondence in the evolution cash flowmarket price than in the one which relates earnings to the price on the stock market. In another study, Board and Day (1989) sustain the reduced amount of information expressed through cash flows, but conclude, however, that there is a high informational content in the traditional rates of return expressed at historical values. The content is also reflected in the evolution of shares on the stock market.…”