28 October 2013
Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?
The main purposes of the article is to examine whether information contained in accruals and cash flows of current earnings helps to predict future earnings. This paper is different in respect to other papers on the topic in that it focuses more on the accounting processes instead of statistical models. Also, this paper uses a less narrow-focused model, which allows for better findings.
It is pretty obvious that earnings performance relies on the earnings’ components found in the accruals and cash flows. But findings show that either investors don’t look at this or looking at them wrong. The financial variables used in the article are Earnings, the Accrual component, and the cash flow component.
Figure 1 shows three graphs, each graph shows extreme earnings, accruals, and cash flows in year 0. The graphs then revert back to the mean over the next few years. Both the earnings and cash flow graphs show a gradual reversion back to the mean while the accrual graph shows steep reversion. This seems to show that accruals do not have as much of an impact on earnings performance. Figure 2 helps to rule out risk-based explanations when it comes to the inability of investors to predict future earnings as it shows positive returns in over 90% of the years.
The basic conclusion of this paper is that stock prices seem to be affected by more than just publically available information. But Sloan doesn’t think that necessarily means that investors are being foolish or the existence of unexploited profit opportunities. Sloan’s conclusion is that it could just be the case of normal result of a portfolio strategy.
Sloan also raises a few questions for future research that relate to earnings management. A particular target of earnings management might be to temporarily manipulate stock price, which might have an effect on the accrual...
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