The pricing of earnings and cash flows and an affirmation of accrual accounting


Under accrual accounting, earnings add to shareholders’ equity. Cash flow generated by a business has no effect on the book value of shareholders’ equity but reduces the book value of net assets employed in business operations. In short, accrual accounting rules prescribe that earnings add to shareholder value, but cash flow is irrelevant to the valuation of equity. This paper documents that the stock market prices equity shares according to this prescription. Earnings are priced positively but, given earnings, a dollar more of free cash flow from a business—cash flow from operations minus cash investment—is, on average, associated with approximately a dollar less in the market value of the business and has no association with changes in the market value of the equity claim on the business. Furthermore, controlling for the cash investment component of free cash flow, cash flow from operations also reduces the market value of the business dollar-for-dollar and is unrelated to the changes in market value of the equity.

This is a preview of subscription content, access via your institution.


  1. 1.

    The statement of cash flows in the United States obeys the cash conservation equation, of course, but the classifications within the statement do not honor the distinction between cash from operations and the disposition of that cash to claimants. For example, cash interest is classified as cash from operations rather than cash paid to debt holders, investment of excess cash in financial assets is treated as investment in operations, and investment in cash is treated as a residual (“change in cash”) rather than an investment in operating cash or financial assets (see Nurnberg 2006).

  2. 2.

    For instance, investment in research and development is treated as cash flow for operations under GAAP while investment in property, plant, and equipment is treated as cash in investing activities only because the latter is capitalized on the balance sheet (and then depreciated), while the former is expensed immediately.

  3. 3.

    The accounting for net financial obligations adjusts the cash flow, F, to report net financial expenses, NFE in the income statement. The difference between NFE and F is reported on the balance sheet: ΔNFO = NFE − F. In more detail, NFE = F − D + Financing accruals, where D is payments of principal (amounts borrowed) net of receipts of principal. Accordingly, ΔNFO = −D + Financing accruals. Combining the accounting for operations and financing activities, Earnings (available to common) = OI − NFE.

  4. 4.

    The system characterized by the eight equations here corresponds to GAAP accounting but (with equity valuation in mind) with a strict proprietorship perspective and a clean distinction between accruals and cash flows that pertain to operating and financing activities. The differences between GAAP and the system here is one of classification of particular items. GAAP does not invoke a strict proprietorship view and makes only an approximate distinction between cash flows and earnings generated by operating activities and those involved in financing activities. GAAP financial statements can be reformulated on a comprehensive income basis with items classified as either operating or financial activities, so the lay out here adds no additional content to GAAP accounting; it is merely a repackaging. See Penman (2010), Chaps. 7 and 9. Our empirical analysis uses GAAP numbers but with this repackaging.

  5. 5.

    From Eq. 9a, the disturbance reflects the end-of-period premium, not the change in premium. However, as the beginning premium is in the regression (with the beginning-of-period book-to-price ratio), the disturbance is effectively the ending premium relative to the beginning premium.

  6. 6.

    Ball (1978) nominates the earnings yield as an indicator of expected returns, and standard formulations show that the P/E ratio (and E/P ratio) is, in part, determined by the expected return. Ohlson (1999) models conservative accounting as a measurement principle that incorporates risk in the accounting numbers.

  7. 7.

    For example, low book-to-price ratios indicate conservative accounting which, given growth in investment, depresses earnings (included in the regression), creates earnings growth, and increases premiums. Penman (1996) documents a positive correlation between book-to-price ratios and earnings-to-price ratios, consistent with conservative accounting (with investment growth) depressing both the earnings yield and book-to-price variables in the regression.

  8. 8.

    Clubb (1996) shows that the Feltham and Ohlson (1995) model implies that free cash flow does not convey incremental information to operating income if the accounting is unbiased but does so under conservative accounting (that induces changes in premiums).

  9. 9.

    The regressions use changes in prices, so an error common to both \( P_{it}^{\text{NOA}} \) and \( P_{it - 1}^{\text{NOA}} \) will not affect the calculation.

  10. 10.

    Variables in Table 2 are on a per-share basis. Accordingly, dividends are cash dividends per share, as in most studies that investigate the information content of dividends. Results were similar when regressions were run on a total dollar basis, with dividends equal to cash dividends plus stock repurchases net of share issues. The latter is strictly appropriate, for returns do not necessarily reconcile to earnings and the change in premium according to Eq. 9 on a per-share basis. Results were also similar when annual coefficient estimates are weighted, in the averaging over years, by the square root of the number of observations for that year. Changes in interest rates affect price changes differentially for firms in the same yearly regression but with different fiscal year ends. However, results were similar when only December 31 fiscal-year-end firms were included each year.

  11. 11.

    Adding the change in dividends, Δd it//P it−1, to the regression suggests a positive signal. The mean coefficient on the dividend change was 4.60, with a t-statistic of 9.61, with little change in the other coefficient estimates, including that on the dividend. The dividend change variable effectively adds d it-1/P it−1 to the regression. Given that a time t−1 variable should not predict time t price changes in an efficient market, this result suggests that d it−1/P it−1 adds to the regression as a predictor of d it /P it−1, so isolating the signal component of d it . Note that the specification assumes that dividends are paid at the end of the year (at time t). So, with dividends paid throughout the year, the measured dividends understate their end-of-period value through compounding. This amount is small for most firms so, while one would expect the error to result in a coefficient less than −1.0, the measurement error cannot explain the size of the negative coefficient.

  12. 12.

    Cash investment in the GAAP cash flow statement includes investment in these financial assets (which is not an investment in operating assets but rather a disposition of net cash from operations). The GAAP number also includes investments in long-term financial assets, but these cannot be isolated using COMPUSTAT data.


  1. Aboody, D., Barth, M., & Kasznik, R. (2004). SFAS No. 123 stock-based compensation expense and equity market values. The Accounting Review, 79(April), 251–275.

    Article  Google Scholar 

  2. Ali, A. (1994). The incremental information content of earnings, working capital from operations and cash flows. Journal of Accounting Research, 32(Spring), 61–74.

    Article  Google Scholar 

  3. Ball, R. (1978). Anomalies in relationships between securities’ yields and yield-surrogates. Journal of Financial Economics, 6(June/September), 103–126.

    Article  Google Scholar 

  4. Ball, R., & Brown, P. (1968). An empirical evaluation of accounting income numbers. Journal of Accounting Research, 6(Autumn), 159–177.

    Article  Google Scholar 

  5. Barth, M. (1994). Fair value accounting: Evidence from investment securities and the market valuation of banks. The Accounting Review, 69(January), 1–25.

    Google Scholar 

  6. Barth, M., Beaver, W., Hand, J., & Landsman, W. (1999). Accruals, cash flows, and equity values. Review of Accounting Studies, 3(December), 205–229.

    Article  Google Scholar 

  7. Bowen, R., Burgstahler, D., & Daley, L. (1987). The incremental information content of accrual versus cash flows. The Accounting Review, 62(October), 723–747.

    Google Scholar 

  8. Campbell, J. Y. (1991). A variance decomposition for stock returns. Economic Journal, 101(March), 157–179.

    Article  Google Scholar 

  9. Charitou, A., & Clubb, C. (1999). Earnings, cash flows and security returns over long return intervals: Analysis and UK evidence. Journal of Business Finance and Accounting, 26(April/May), 283–312.

    Article  Google Scholar 

  10. Cheng, C., Liu, C., & Schaefer, T. (1996). Earnings permanence and the incremental information content of cash flows from operations. Journal of Accounting Research, 34(Spring), 173–181.

    Article  Google Scholar 

  11. Clubb, C. (1995). An empirical study of the information content of accounting earnings, funds flows and cash flows in the UK. Journal of Business Finance and Accounting, 22(January), 35–52.

    Google Scholar 

  12. Clubb, C. (1996). Valuation and clean surplus accounting: Some implications of the Feltham and Ohlson model for the relative information content of earnings and cash flows. Contemporary Accounting Research, 13(Spring), 329–337.

    Google Scholar 

  13. Dechow, P. (1994). Accounting earnings and cash flows as measures of firm performance: The role of accounting accruals. Journal of Accounting and Economics, 18(July), 3–42.

    Article  Google Scholar 

  14. Dechow, P., & Dichev, I. (2002). The quality of accruals and earnings: The role of accrual estimation Errors. The Accounting Review, 77(Supplement), 35–59.

    Article  Google Scholar 

  15. Dechow, P., Kothari, S., & Watts, R. (1998). The relation between earnings and cash flows. Journal of Accounting and Economics, 25(May), 133–168.

    Article  Google Scholar 

  16. Dechow, P., Richardson, S., & Sloan, R. (2008). The persistence and pricing of the cash flow component of earnings. Journal of Accounting Research, 46(June), 537–566.

    Article  Google Scholar 

  17. Easton, P., & Harris, T. (1991). Earnings as an explanatory variable for returns. Journal of Accounting Research, 29(Spring), 9–36.

    Google Scholar 

  18. Easton, P., Harris, T., & Ohlson, J. (1992). Aggregate accounting earnings can explain most of security returns: The case of long event windows. Journal of Accounting and Economics, 15(June–September), 119–142.

    Article  Google Scholar 

  19. Fairfield, P., Whisenant, J., & Yohn, T. (2003a). Accrued earnings and growth: Implications for future profitability and market mispricing. The Accounting Review, 78(January), 353–371.

    Article  Google Scholar 

  20. Fairfield, P., Whisenant, J., & Yohn, T. (2003b). The differential persistence of accruals and cash flows for future operating income versus future profitability. Review of Accounting Studies, 8(June–September), 221–243.

    Article  Google Scholar 

  21. Fama, E., & French, K. (1992). The cross-section of expected stock returns. Journal of Finance, 47(June), 427–465.

    Article  Google Scholar 

  22. Feltham, G., & Ohlson, J. (1995). Valuation and clean surplus accounting for operating and financial activities. Contemporary Accounting Research, 12(Spring), 689–731.

    Google Scholar 

  23. Francis, J., Schipper, K., & Vincent, L. (2003). The relative incremental explanatory power of earnings and alternative (to earnings) performance measures for returns. Contemporary Accounting Research, 20(Spring), 121–164.

    Article  Google Scholar 

  24. Holthausen, R., & Watts, R. (2001). The relevance of the value-relevance literature for financial accounting standard setting. Journal of Accounting and Economics, 31(September), 3–75.

    Article  Google Scholar 

  25. Jennings, R. (1990). A note on interpreting incremental information content. The Accounting Review, 65(October), 925–932.

    Google Scholar 

  26. Landsman, W. (1986). An empirical investigation of pension fund property rights. The Accounting Review, 61(October), 662–691.

    Google Scholar 

  27. Lipe, R. (1986). The information contained in components of earnings. Journal of Accounting Research, 24(Supplement), 37–64.

    Article  Google Scholar 

  28. Miller, M., & Modigilani, F. (1961). Dividend policy, growth and the valuation of shares. Journal of Business, 34(October), 411–433.

    Google Scholar 

  29. Nissim, D., & Penman, S. (2001). Ratio analysis and equity valuation: From research to practice. Review of Accounting Studies, 6(March), 109–154.

    Article  Google Scholar 

  30. Nurnberg, H. (2006). Perspectives on the cash flow statement under FASB statement no. 95. Occasional Paper Series, Center for Excellence in Accounting and Security Analysis, Columbia Business School, at

  31. Ohlson, J. (1995). Earnings, book values, and dividends in equity valuation. Contemporary Accounting Research, 12(Spring), 661–687.

    Article  Google Scholar 

  32. Ohlson, J. (1999). Conservative accounting and risk. Unpublished paper, New York University.

  33. Ohlson, J. (2005). The basic concepts related to returns on earnings regressions. Journal of Contemporary Accounting and Economics, 1(June), 93–102.

    Google Scholar 

  34. Ohlson, J., & Penman, S. (1992). Disaggregated accounting data as explanatory variables for returns. Journal of Accounting, Auditing and Finance, (Spring), 553–573.

  35. Ohlson, J., & Shroff, P. (1992). Changes versus levels in earnings as explanatory variables for returns: Some theoretical considerations. Journal of Accounting Research, 30(Autumn), 210–226.

    Article  Google Scholar 

  36. Penman, S. (1996). The articulation of price-earnings ratios and market-to-book ratios and the evaluation of growth. Journal of Accounting Research, 34(Autumn), 235–259.

    Article  Google Scholar 

  37. Penman, S. (2010). Financial statement analysis and security valuation (4th ed.). New York: The McGraw-Hill Companies.

    Google Scholar 

  38. Penman, S., & Sougiannis, T. (1997). The dividend displacement property and the substitution of anticipated earnings for dividends in equity valuation. The Accounting Review, 72(January), 1–21.

    Google Scholar 

  39. Rayburn, J. (1986). The association of operating cash flow and accruals with security returns. Journal of Accounting Research, 24(Supplement), 112–133.

    Article  Google Scholar 

  40. Richardson, S., Sloan, R., Soliman, M., & Tuna, İ. (2006). The implications of accounting distortions and growth for accruals and profitability. The Accounting Review, 81(May), 713–743.

    Article  Google Scholar 

  41. Shroff, P. (1995). Determinants of the returns-earnings correlation. Contemporary Accounting Research, 12(Fall), 41–55.

    Article  Google Scholar 

  42. Sloan, R. (1996). Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review, 71(July), 289–315.

    Google Scholar 

  43. Wilson, P. (1987). The incremental information content of accrual and funds components of earnings after controlling for earnings. The Accounting Review, 62(April), 293–322.

    Google Scholar 

Download references


We are thankful for the comments in workshops at Duke University, Stanford University, Washington University, Penn State University, University of Technology Sydney, University of British Columbia, INSEAD, George Washington University, UCLA, Temple University, EIASM Workshop on Capital Markets Research (2003) at Goethe University, and also Bjorn Jorgensen, Doron Nissim, and Jacob Thomas.

Author information



Corresponding author

Correspondence to Stephen H. Penman.

Appendix: Note on return regression models involving accounting numbers

Appendix: Note on return regression models involving accounting numbers

The point that specification must reflect the accounting structure that governs the numbers can be illustrated by asking how the cost of goods sold (CGS) number on income statements is priced in the market: is it a reduction of the value of shareholders’ equity as the accounting prescribes? To answer this question, one might naively run the following cross-sectional regression using a levels specification:

$$ P_{it} = a + b{\text{CGS}}_{it} + e_{it} , $$

where P it is the market value of the shares of firm i at date t. Or, using a “changes” specification, with stocks returns as the regressand:

$$ P_{it} + d_{it} - P_{it - 1} = \alpha + \beta \Updelta {\text{CGS}}_{it} + \varepsilon_{it} . $$

The changes versus levels specification issue aside, an accountant might well object. Cost of goods sold is an expense (a reduction in shareholder value), yet the estimated slope coefficients from these equations are probably positive. Indeed, using data from 1963 to 2001 described in Sect. 2, the estimate of coefficient, b, is 1.12 (with a t-statistic of 13.52 calculated from mean estimates from annual cross-sectional regressions) and the estimate of β, after deflating each variable by beginning-of-period price, P it−1, is 0.23 (with a t-statistic of 8.62). As a matter of statistical correlation, the estimates are appropriate, but they do not inform. Cost of goods sold is part of the calculation of earnings; by accounting principle, it is involved with the sales with which it is matched to determine gross margin, so cost of goods sold cannot be considered without the matching sales. Specifying regressions under this dictate,

$$ P_{it} = a + b_{1} {\text{Sales}}_{it} + b_{2} {\text{CGS}}_{it} + e_{it} $$
$$ P_{it} + d_{it} - P_{it - 1} = \alpha + \beta_{1} \Updelta {\text{Sales}}_{it} + \beta_{2} \Updelta {\text{CGS}}_{it} + \varepsilon_{it} $$

Using our data, the estimate of b 2 is reliably negative (−3.94 with a t-statistic of −17.74), as is the estimate of β 2 (−0.74 with a t-statistic of −9.48); the estimates of b 1 and β 1 are reliably positive, at 3.66 and 0.82, respectively.

The corrected specifications follow the form of an accounting relation: revenues − cost of goods sold = gross margin. Lipe (1986) and Ohlson and Penman (1992), among others, invoke income statement relations of this form to examine the pricing of income statement components. Aboody et al. (2004) embed income statement relations in a regression model to examine whether the stock market prices grants of employee stock options as an expense. Landsman (1986) and Barth (1994), among others, employ the balance sheet equation in specifying regressions involving assets and liabilities. Income statement and balance sheet equations are only two of several accounting relations that govern accrual accounting, but the point is clear: a regression specification involving accounting numbers should be determined by the structure that delivers the numbers, for that structure prescribes how they are to be interpreted.

A further issue arises in interpreting estimated coefficients in regression equations like those above: coefficients on included variables are affected by correlation with omitted information (in the regression disturbance). The regressions developed in this paper not only mirror the accounting relations governing earnings and cash flow but also provide a characterization of omitted information and an interpretation of how earnings and cash flows correlate with the omitted information.

Rights and permissions

Reprints and Permissions

About this article

Cite this article

Penman, S.H., Yehuda, N. The pricing of earnings and cash flows and an affirmation of accrual accounting. Rev Account Stud 14, 453–479 (2009).

Download citation


  • Accruals
  • Cash flow
  • Accrual accounting

JEL Classification

  • G14
  • M40
  • M41