Do Firm-Specific Characteristics of Accruals and Operating Cash Flows Predict Earnings Persistence and Stock Prices?

• In Event: Valuation

Abstract

Research on the differential persistence of accruals and operating cash flows generally employs cross-sectional analyses. However, financial analysis is generally performed at the firm level, and prior research suggests time-series estimates of firm-level differential persistence of accruals and operating cash flows cannot be exploited for forecasting or trading purposes. We mathematically decompose earnings persistence into three firm-specific characteristics of accruals and operating cash flows: differential persistence, the relative size, and the relative sign of these components. Using a large sub-sample of observations where the persistence of operating cash flows is greater than the persistence of accruals, we find that a model that combines these three firm-specific characteristics improves forecasts of earnings persistence relative to forecasts of earnings persistence based on historical aggregate earnings. We also find that trading strategies based on our model’s firm-specific forecasts earn abnormal returns, and that these returns do not diminish over time, unlike the returns from the cross-sectional accrual anomaly. Our study demonstrates that historical firm-specific estimates of differential persistence can be used to improve forecasts of year-ahead earnings persistence and identify equity mispricing.

Authors

• Andrew C Call, The University of Georgia

• Max Hewitt, Indiana University Bloomington

• Terry J Shevlin, University of California, Irvine

• Teri Lombardi Yohn, Indiana University Bloomington