Review of Accounting Studies

, Volume 7, Issue 2–3, pp 195–215

The Role of Volatility in Forecasting

  • Bernadette A. Minton
  • Catherine M. Schrand
  • Beverly R. Walther
Article

Abstract

Theories of underinvestment propose a link between cash flow volatility and investment and subsequent cash flow and earnings levels. Consistent with these theories, our results indicate that forecasting models that include volatility as an explanatory variable have greater accuracy and lower bias than forecasting models that exclude volatility. The improvement in forecast accuracy and bias is greatest when the firm is most likely to experience underinvestment. The profitable implementation of a trading strategy based on these findings, however, suggests that equity market participants do not incorporate fully the information in historical volatility when forecasting future firm performance.

cash flow forecasting underinvestment volatility 

Preview

Unable to display preview. Download preview PDF.

Unable to display preview. Download preview PDF.

References

  1. Abarbanell, J. S. and B. J. Bushee. (1997). “Fundamental Analysis, Future Earnings, and Stock Prices.” Journal of Accounting Research 35, 1-24.Google Scholar
  2. Abarbanell, J. S. and B. J. Bushee. (1998). “Abnormal Returns to a Fundamental Analysis Strategy.” The Accounting Review 73, 19-45.Google Scholar
  3. Albrecht, W. D. and F. M. Richardson. (1990). “Income Smoothing by Economy Sector.” Journal of Business, Finance and Accounting 17, 713-730.Google Scholar
  4. Alford, A. W. and P. G. Berger. (1999). “A Simultaneous Equations Analysis of Forecast Accuracy, Analyst Following, and Trading Volume.” Journal of Accounting, Auditing and Finance 14, 219-240.Google Scholar
  5. Ali, A., L.-S. Hwang and M. A. Trombley. (2000). “Accruals and Future Stock Returns: Tests of the Naive Investor Hypothesis.” Journal of Accounting, Auditing and Finance 15, 161-181.Google Scholar
  6. Amihud, Y. and H. Mendelson. (1988). “Liquidity and Asset Prices: Financial Management Implications.” Financial Management 7, 5-15.Google Scholar
  7. Ashton, R. H. (1982). Human Information Processing in Accounting, American Accounting Association, Sarasota, FL.Google Scholar
  8. Barth, M. E., D. P. Cram and K. K. Nelson. (2001). “Accruals and the Prediction of Future Cash Flows.” The Accounting Review 76, 27-58.Google Scholar
  9. Beaver, W., P. Kettler and M. Scholes. (1970). “The Association between Market Determined and Accounting Determined Risk Measures.” The Accounting Review 45, 654-682.Google Scholar
  10. Berger, P. G., E. Ofek and I. Swary. (1996). “Investor Valuation of the Abandonment Option.” Journal of Financial Economics 42, 257-287.Google Scholar
  11. Bernard, V. L. and T. L. Stober. (1989). “The Nature and Amount of Information in Cash Flows and Accruals.” The Accounting Review 64, 624-652.Google Scholar
  12. Bowen, R. M., D. Burgstahler and L. A. Daley. (1986). “Evidence on the Relationships between Earnings and Various Measures of Cash Flow.” The Accounting Review 61, 713-725.Google Scholar
  13. Dechow, P. M. (1994). “Accounting Earnings and Cash Flows as Measures of Firm Performance: The Role of Accounting Accruals.” Journal of Accounting and Economics 18, 3-42.Google Scholar
  14. Dixit, A. K. and R. S. Pindyck. (1993). Investment Under Uncertainty, Princeton, NJ: Princeton Press.Google Scholar
  15. Fazzari, S. M., R. G. Hubbard and B. C. Petersen. (1988). “Financing Constraints and Corporate Investment.” Brookings Papers on Economic Activity, 141-195.Google Scholar
  16. Fazzari, S. M., R. G. Hubbard and B. C. Petersen. (1998). “Investment-Cash Flow Sensitivities are Useful: A Comment on Kaplan and Zingales.” Working Paper, Columbia University.Google Scholar
  17. Finger, C. (1994). “The Ability of Earnings to Predict Future Earnings and Cash Flow.” Journal of Accounting Research 32, 210-223.Google Scholar
  18. Francis, J., P. Olsson and D. R. Oswald. (2000). “Comparing the Accuracy and Explainability of Dividend, Free Cash Flow, and Abnormal Earnings Equity Value Estimates.” Journal of Accounting Research 38, 45-70.Google Scholar
  19. Froot, K., D. Scharfstein and J. Stein. (1993). “Risk Management: Coordinating Investment and Financing Policies.” Journal of Finance 48, 1629-1658.Google Scholar
  20. Gebhardt, W. R., C. M. C. Lee and B. Swaminathan. (2001). “Toward an Implied Cost of Capital.” Journal of Accounting Research 39, 135-176.Google Scholar
  21. Geczy, C., B. A. Minton and C. Schrand. (1997). “Why Firms Use Currency Derivatives.” Journal of Finance 52, 1323-1354.Google Scholar
  22. Graham, J. and C. Smith. (1999). “Tax Incentives to Hedge.” Journal of Finance 54, 2241-2262.Google Scholar
  23. Guay, W. (1999). “The Impact of Derivatives on Firm Risk: An Empirical Examination of New Derivative Users.” Journal of Accounting and Economics 26, 319-351.Google Scholar
  24. Hoshi, T., A. Kashyap and D. Scharfstein. (1991). “Corporate Structure, Liquidity, and Investment: Evidence from Japanese Industrial Groupings.” Quarterly Journal of Economics 56, 33-60.Google Scholar
  25. Huberts, L. C. and R. J. Fuller. (1995). “Predictability Bias in the U.S. Equity Market.” Financial Analysts Journal 51, 12-28.Google Scholar
  26. Kaplan, S. N. and L. Zingales. (1997). “Do Investment-Cash Flow Sensitivities Provide Useful Measures of Financing Constraints?” Quarterly Journal of Economics 112, 169-215.Google Scholar
  27. Lamont, O. (1997). “Cash Flow and Investment: Evidence from Internal Capital Markets.” Journal of Finance 52, 83-111.Google Scholar
  28. Lev, B. and S. R. Thiagarajan. (1993). “Fundamental Information Analysis.” Journal of Accounting Research 31, 190-215.Google Scholar
  29. Lim, T. (2001). “Rationality and Analysts' Forecasts Bias.” Journal of Finance 61, 369-385.Google Scholar
  30. Majd, S. and R. S. Pindyck. (1987). “Time to Build, Option Value and Investment Decisions.” Journal of Financial Economics 18, 7-27.Google Scholar
  31. Mian, S. L. (1996). “Evidence on Corporate Hedging Policy.” Journal of Financial and Quantitative Analysis 31, 419-439.Google Scholar
  32. Michelson, S. E., J. Jordan-Wagner and C. W. Wootton. (1995). “A Market Based Analysis of Income Smoothing.” Journal of Business, Finance and Accounting 22, 1179-1193.Google Scholar
  33. Minton, B. and C. Schrand. (1999). “The Impact of Cash Flow Volatility on Discretionary Investment and the Costs of Debt and Equity Financing.” Journal of Financial Economics 54, 423-460.Google Scholar
  34. Minton, B., C. Schrand and B. Walther. (2001). “Forecasting Cash Flow for Valuation: Is Cash Flow Volatility Informative?” Working Paper, Ohio State University.Google Scholar
  35. Myers, S. C. (1977). “Determinants of Corporate Borrowing.” Journal of Financial Economics 5, 147-175.Google Scholar
  36. Nance, D. R., C. W. Smith, Jr. and C. W. Smithson. (1993). “On the Determinants of Corporate Hedging.” Journal of Finance 48, 267-284.Google Scholar
  37. O'Brien, P. C. and R. Bhushan. (1990). “Analyst Following and Institutional Ownership.” Journal of Accounting Research 28, 55-76.Google Scholar
  38. Pindyck, R. S. (1988). “Irreversible Investment, Capacity Choice, and the Value of the Firm.” American Economic Review 78, 969-985.Google Scholar
  39. Shapiro, A. and S. Titman. (1986). “An Integrated Approach to Corporate Risk Management.” In: J. Stern and D. Chew (eds.), The Revolution in Corporate Finance. England: Basil Blackwell Ltd, Cambridge, MA: Basil Blackwell, Inc.Google Scholar
  40. Sloan, R. (1996). “Using Earnings and Free Cash Flow to Evaluate Corporate Performance.” Journal of Applied Corporate Finance, 70-78.Google Scholar
  41. Smith, C. W. and R. M. Stulz. (1985). “The Determinants of Firms' Hedging Policies.” Journal of Financial and Quantitative Analysis 20, 391-405.Google Scholar
  42. Trigeorgis, L. (1996). Real Options: Managerial Flexibility and Strategy in Resource Allocation. Cambridge, MA: MIT Press.Google Scholar
  43. Walther, B. R. and R. H.Willis. (1999). “Are Earnings Surprises Costly?”Working Paper, Northwestern University.Google Scholar
  44. Waymire, G. (1985). “Earnings Volatility and Voluntary Management Forecast Disclosure.” Journal of Accounting Research 23, 268-295.Google Scholar
  45. Weary, T. M. (1998). “Steady as She Goes! Earnings Stability and Investment Performance.” Journal of Investing 7, 54-60.Google Scholar
  46. Wilson, G. P. (1987). “The Incremental Information Content of the Accrual and Funds Components of Earnings after Controlling for Earnings.” The Accounting Review 62, 293-322.Google Scholar

Copyright information

© Kluwer Academic Publishers 2002

Authors and Affiliations

  • Bernadette A. Minton
  • Catherine M. Schrand
  • Beverly R. Walther

There are no affiliations available

Personalised recommendations