Abstract
We provide empirical evidence on the quality of street cash flow from operations (CFO) as an alternative financial performance summary measure. We focus our investigation on the quality of the items analysts exclude in their determination of street CFO. Based on a sample of 8,518 firm-year observations over the 1993–2008 period, we find that the street CFO number is generally higher than the GAAP CFO number, indicating that analysts typically make CFO-increasing exclusions. Our inspection of hand-collected analyst reports reveals that, while some analysts make sophisticated exclusions of transitory cash items, many others ignore working capital and other accruals when adjusting forecasted earnings to arrive at their street CFO forecasts. We find that street CFO exclusions are negatively associated with future operating earnings, suggesting that these exclusions are not fully transitory or unimportant in forecasting future performance. Our results also indicate that street CFO exclusions are less transitory than the implicit accrual component of analysts’ street earnings exclusions. These results suggest that the average quality of analysts’ street CFO exclusions is quite low and that it is even lower than the quality of their implied accrual exclusions. Moreover, we find that investors perceive analysts’ CFO exclusions to be of such low quality to render street CFO measures less informative than GAAP CFO figures. Finally, we find that analyst conflicts of interest and (to some extent) the greater inherent volatility of firms’ CFO series contribute to the low-quality nature of analysts’ street CFO exclusions.
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Notes
We base our large-sample analyses on the I/B/E/S actual CFO metric (an ex post FDP-adjusted measure based on analysts’ ex ante forecasts). Our small-sample analyses are based directly on hand-collected data from analysts’ ex ante reports. We acknowledge that we often discuss “analysts’ exclusions” even though the actual CFO measure is determined ex post by I/B/E/S using the majority rule (based on ex ante exclusions from analysts’ CFO forecasts).
Consistent with this line of research, we use the term “sophistication” to refer to the quality of analysts’ derivation of their street CFO forecasts. Sophisticated forecasts are those derived from detailed predictions of working capital accruals and other non-cash add-backs to forecasted earnings, whereas less-sophisticated (or naïve) forecasts are those derived by simply adding back predictions of depreciation expense to the forecasted earnings figure.
Similarly, Pae et al. (2007) find that analysts experience an improvement in earnings forecast accuracy when they issue CFO forecasts. However, they find that the indirect benefit of CFO forecasts on earnings forecast accuracy is limited in that CFO forecast issuers do not outperform the earnings forecast accuracy of non-issuers.
The quality of analyst street metrics may change over time due to several factors including regulatory intervention, procedural and definitional changes undertaken by FDPs, changes in accounting standards over time, and other time trend effects. We address the potential influence of these time-related factors in our empirical tests to follow.
EPS GAAP-OP and EPS GAAP-BXI are the applicable basic or diluted per share figure matched to the I/B/E/S definition. We compute CFO GAAP-COP as follows: we begin with Compustat’s cash flow from operations (annual data item OANCF) and subtract the cash portion of extraordinary items and discontinued operations (annual data item XIDOC). We then divide this value by the number of common shares used to calculate basic EPS (annual data item CSHPRI) if the I/B/E/S figures are reported on a primary share basis. If the I/B/E/S figures are reported on a diluted share basis, we multiply the cash flow value by the inverse of the ratio of basic EPS to diluted EPS, both before extraordinary items and discontinued operations (annual data item EPSPX ÷ data item EPSFX), or the inverse of the dilution factor reported in I/B/E/S if data item EPSPX or EPSFX is missing or equal to zero.
We find similar evidence when we define future operating performance as one-year-ahead GAAP CFO per share or one-year-ahead street earnings or street CFO per share.
In robustness tests, we find similar results when we use the raw values of SDC/SDE rather than the HI_SDC/SDE indicator variable. Thus, our results are not sensitive to the use of the top quintile threshold.
We thank Jay Ritter for sharing the modified Carter-Manaster reputation rankings (available at http://bear.warrington.ufl.edu/ritter/ipodata.htm).
We compute total assets per share by scaling total assets with the applicable number of common or diluted shares used to calculate basic or diluted EPS as matched to the I/B/E/S/definition (see footnote 6 for further details).
We obtained the Broker Translation File from I/B/E/S in 2005. For firm-years after 2005, we supplement our identification of brokerage/research firm names using the I/B/E/S recommendation detail file, which include analyst names and abbreviated broker names (see Bradshaw et al. 2012 for a similar approach).
This approach is consistent with Givoly et al. (2009), who find some improvement in analysts’ incorporation of working capital and other accruals into their CFO forecasts over the fiscal year. To validate our approach, we inspect the reports of a small subset of analysts issuing multiple CFO forecasts for the same firm-year. We observe that some analysts do not incorporate certain accruals when deriving early-year CFO forecasts but begin to include them in later-year forecasts. From these reports, it appears that some analysts begin to incorporate these items after firms either release an earnings report or provide management forecast guidance. This anecdotal evidence is consistent with Christensen et al. (2011), who find that analysts’ computation of street earnings is influenced by management earnings guidance.
Of the 110 reports, about 87 % cover the 2004–2008 period. This data sampling reflects (1) a large number of missing reports in Investext prior to 2004 and (2) the higher frequency of CFO forecasts for each firm in later years.
In some cases, we refer to the analyst’s computation of actual CFO for the prior fiscal year along with the firm’s prior-year cash flow statement to help identify the items excluded from the analyst’s current-year CFO forecast.
Yoo et al. (2011) list seven CFO definitions commonly used by analysts. Five of these definitions distinctly exclude changes in working capital accruals as an adjustment to forecasted net income.
For example, the 2004 CIBC World Markets analyst report for Exxon Mobil defines street CFO as forecasted CFO plus gains on asset sales and dispositions.
See Black and Christensen (2009) for a similar approach in assessing the average magnitude and statistical significance of the items excluded from manager-adjusted pro forma earnings.
Our results are unchanged if we do not winsorize these variables at the 1 and 99 % levels.
In robustness tests, we include excess tax benefits from employee stock options (ESOTAX) as an additional GAAP CFO adjustment. We conduct this analysis for firm-years with non-missing values of ESOTAX as reported in the operating activities section of the cash flow statement. This data item is missing for most of our firm-years prior to 2002, primarily due to changes in accounting for stock options coinciding with the 2001 financial reporting scandals and the 2004 release of FAS 123R. Also, we exclude firm-years in which ESOTAX is reported as a cash flow from financing activities. We do not find a significant association between CFOEXC and ESOTAX, indicating that most analysts do not exclude this tax benefit when forecasting street CFO. Analysts’ failure to exclude this tax benefit from CFO would be considered unsophisticated since prior evidence suggests that ESOTAX is nonrecurring and not relevant for forecasting core CFO performance (Fink 2002; Mulford and Comiskey 2005; Hribar and Nichols 2008).
See Richardson et al. (2005) for a similar specification of the relative persistence of accruals and cash flows.
In robustness tests, we find similar results when we use Eq. 4 to estimate our results.
In robustness tests, we continue to find a significantly negative coefficient on CFOEXC when we control for the differential persistence of the recurring and special items components of analysts’ street earnings exclusions.
In unreported results, we do not find a significant difference in investors’ reaction to EARNEXC and CFOEXC following SEC scrutiny into the use of non-GAAP financial metrics. This result suggests that investors do not perceive street CFO exclusions to be of higher quality following SEC scrutiny, despite post-intervention improvements in the transitory nature of these exclusions.
In untabulated results, we find that the magnitude of analysts’ street CFO exclusions is positively associated with both TOPTIER and HI_SDC/SDE. This result suggests that strongly conflicted analysts and analysts following firms with high CFO volatility tend to make larger CFO-increasing exclusions when deriving the street CFO metric.
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Acknowledgments
We appreciate helpful comments from Larry Brown, Andy Call, Russ Lundholm (editor), an anonymous reviewer, Ben Whipple, and workshop participants at Georgia State University, the University of Padova, the 2011 SESARC Conference, and the 2012 AAA Annual Meetings. We also thank the following Georgia State University doctoral students for their comments and suggestions: Heba Abdel-Rahim, Stuart Smith, Han Stice, Roger White, Tu Xu, Di Yang, and Zhen Zhang. Finally, we thank Samuel Freeman, Jomsurang Ruangprapun, Ramone Sutherland, and Eric Swenson for their excellent research assistance.
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Appendices
Appendix 1: Variable definitions
Primary variables | |
FUTURE GAAP-OP | One-year-ahead GAAP EPS from continuing operations (EPS GAAP-OP ). |
CFO IBES | Analyst-adjusted cash flow from continuing operations (CFO) per share from the I/B/E/S split-unadjusted actual file |
CFO GAAP-COP | GAAP cash flow from continuing operations computed as Compustat’s cash flow from operations (annual data item OANCF) minus the cash portion of extraordinary items and discontinued operations (annual data item XIDOC). CFO GAAP-COP is the applicable basic or diluted per share figure matched to the I/B/E/S definition |
EPS IBES | Analyst-adjusted street EPS from the I/B/E/S split-unadjusted actual file |
EPS GAAP-OP | GAAP EPS from continuing operations. EPS GAAP-OP is the applicable basic or diluted per share figure matched to the I/B/E/S definition |
EPS GAAP-BXI | GAAP EPS before extraordinary items and discontinued operations. EPS GAAP-BXI is the applicable basic or diluted per share figure matched to the I/B/E/S definition |
FE_EPS IBES | I/B/E/S street earnings forecast error, calculated as EPS IBES minus the most recent analyst street earnings forecast issued within 90 days before the earnings announcement date |
FE_EPS GAAP-OP | GAAP operating earnings forecast error, calculated as EPS GAAP-OP minus the most recent analyst street earnings forecast issued within 90 days before the earnings announcement date |
FE_CFO IBES | I/B/E/S street CFO forecast error, calculated as CFO IBES minus the most recent analyst CFO forecast issued within 90 days before the earnings announcement date |
FE_CFO GAAP-COP | GAAP CFO forecast error, calculated as CFO GAAP-COP minus the most recent analyst CFO forecast issued within 90 days before the earnings announcement date |
CFOEXC | Total street CFO exclusions per share, calculated as CFO IBES minus CFO GAAP-COP |
EARNEXC | Total street earnings exclusions per share, calculated as EPS IBES minus EPS GAAP-BXI |
BHAR | Compounded buy-and-hold return over the three-day window centered on the earnings announcement date less the three-day value-weighted market return |
TOPTIER | Equals 1 if the average Carter-Manaster reputation rank of the analysts issuing CFO forecasts for each firm-year is greater than or equal to 8.1 and 0 otherwise |
HIRANK | Equals 1 if the analyst’s Carter-Manaster reputation rank is greater than or equal to 8.1 and 0 otherwise |
SDC/SDE | The standard deviation of CFO divided by the standard deviation of net income over at least three of the past eight fiscal years. Net income and CFO are both scaled by end-of-year total assets |
HI_SDC/SDE | Equals 1 for those firm-years with a SDC/SDE value that ranks in the top quintile of the sample and 0 otherwise |
Exclusion variables from full-text analyst reports | |
ΔWC | Equals 1 if the analyst’s full-text report discloses the exclusion of changes in working capital accruals from the analyst’s computation of the street CFO forecast and 0 otherwise |
DEFTAX | Equals 1 if the analyst’s full-text report discloses the exclusion of deferred taxes from the analyst’s computation of the street CFO forecast and 0 otherwise |
DEFCOMP | Equals 1 if the analyst’s full-text report discloses the exclusion of stock-based and other deferred compensation from the analyst’s computation of the street CFO forecast and 0 otherwise |
EQUITYINC | Equals 1 if the analyst’s full-text report discloses the exclusion of income/loss in equity affiliates from the analyst’s computation of the street CFO forecast, and 0 otherwise. |
GAINLOSS | Equals 1 if the analyst’s full-text report discloses the exclusion of gains/losses on the sale of assets from the analyst’s computation of the street CFO forecast and 0 otherwise |
NONRECUR | Equals 1 if the analyst’s full-text report discloses the exclusion of other nonrecurring items from the analyst’s computation of the street CFO forecast and 0 otherwise. These nonrecurring items include restructuring charges, litigation payments, one-time pension cash contributions, and nonrecurring changes in working capital accruals |
CAPEX | Equals 1 if the analyst’s full-text report discloses the deduction of capital expenditures from CFO to arrive at a forecast of free cash flow and 0 otherwise |
NO_EXCL | Equals 1 if the analyst's full-text report discloses a street CFO forecast with no clear identifiable exclusion and 0 otherwise |
NI + DEPR | Equals 1 if the analyst's full-text report discloses a naïve CFO forecast by adding back depreciation expense to forecasted earnings and 0 otherwise |
GAAP CFO line item variables from Compustat | |
ΔREC | Decrease (increase) in accounts receivable (Compustat annual item RECCH) |
ΔINV | Decrease (increase) in inventories/stocks (Compustat annual item INVCH) |
ΔAP | Increase (decrease) in accounts payable and accrued liabilities (Compustat annual item APALCH) |
ΔTAX | Increase (decrease) in accrued income taxes (Compustat annual item TXACH) |
ΔOTHER | Net change in other assets and liabilities (Compustat annual item AOLOCH) |
DEPR | Depreciation and amortization (Compustat annual item DPC) |
DEFINCTAX | Deferred income tax expense (Compustat annual item TXDC) |
EQUITYSUB | Equity in the net loss (earnings) of unconsolidated subsidiaries (Compustat annual item ESUBC) |
GAINPPE | Loss (gain) on the sale of property, plant, and equipment and investments (Compustat annual item SPPIV) |
Control variables | |
GROWTH | One-year change in sales scaled by total common shares outstanding |
LOSS | Equals 1 if the firm reports a GAAP loss from continuing operations in the current fiscal year; 0 otherwise |
SIZE | Log of total assets in $ millions at the end of the fiscal year |
SDE | Standard deviation of net income scaled by end-of-year total assets over at least three of the past eight fiscal years |
BOOKMKT | The ratio of book to market value of equity at the end of the fiscal year |
POSTSEC | Equals 1 for all firm-years following the December 2001 SEC cautionary advice on the use of non-GAAP financial measures; 0 otherwise |
Appendix 2: Examples of analyst street CFO definitions
Company name and fiscal year end | Analyst firm and report date | Street CFO definition |
|---|---|---|
Williams Cos. FYE 12/31/2000 | Morgan Stanley 10/27/2000 | After-tax cash flow from operations = Net Income + Depreciation + Deferred Taxes |
Exxon Mobil FYE 12/31/2004 | A. G. Edwards 07/30/2004 | Cash earnings = Net Income + Depreciation |
Oracle Corp. FYE 05/31/2006 | Credit Suisse First Boston 05/30/2006 | Cash flow from operations = Net Income + Depreciation + Changes in Working Capital Accruals + Other |
DHT Holdings FYE 12/31/2008 | J. P. Morgan 11/19/2008 | Cash flow from operations = Net Income + Depreciation + Changes in Working Capital Accruals |
Chesapeake Energy FYE 12/31/2008 | J. P. Morgan 01/28/2009 | Discretionary cash flow from operations = Net Income + Depreciation + Deferred taxes + Other |
Carrizo Oil & Gas FYE 12/31/2006 | RBC Capital Markets 01/22/2007 | Cash flow from operations = EBIT + Depreciation − Cash Interest − Cash taxes |
Unit Corp. FYE 12/31/2008 | SunTrust Robinson Humphrey 01/22/2009 | Cash flow from operations before working capital = Recurring Net Income + Depreciation − Capitalized Interest + Deferred taxes |
International Paper FYE 12/31/2007 | Buckingham Research 04/18/2007 | Discretionary cash flow from operations = EBITDA − Cash Taxes & Interest + Changes in Working Capital Accruals − Capital Expenditures |
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Brown, N.C., Christensen, T.E. The quality of street cash flow from operations. Rev Account Stud 19, 913–954 (2014). https://doi.org/10.1007/s11142-014-9276-9
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DOI: https://doi.org/10.1007/s11142-014-9276-9