Implications of the Cash Component of Earnings for Earnings Persistence and Stock Returns

The main objective of this paper is to examine the persistence, pricing and economic significance of the cash component of earnings in U.K. listed firms from 1981 to 2013. In so doing, we break down the cash component of earnings into changes in the cash balance and into issuances/distributions to debtholders and equity holders. We find that the cash component of earnings is more persistent than the accrual component and that this higher persistence can be attributed primarily to cash distributed to equity holders. Cash retained by the firm as changes in the cash balance also appears to be more persistent than accruals, whereas cash attributed to debtholders has approximately the same persistence level as accruals.

The results from our pricing models support the naïve investor hypothesis and show both that future stock returns have the strongest positive correlation with the most persistent cash subcomponent of earnings and that investors can devise a profitable investment strategy by investing in companies that have high cash distributions to equity holders. Our results are consistent across subperiods – when controlling for changes in financial reporting standards and the economic environment – and across different size groupings.

Keywords: Earnings, Cash flows, Profitability, Stock Returns, U.K.

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