Abstract
Measures of economic performance, such as accounting earnings, working capital and cash flows, have been evaluated in tests of relative explanatory power of regressions of market returns on earnings, working capital and cash flows. We employ a different test. Using Basu’s (J Finance 663–682, 1977) investment trading strategy, we measure portfolio returns based on these three accounting measures of earnings. The objective is to ascertain whether investment performance also supports the findings of the explanatory power studies that accounting earnings is the premier measure of performance. The evidence does not support this conclusion. Our findings are at variance with prior conclusions that accounting earnings is more useful than cash flow. The Basu trading strategy is effective for all three measures. Excess market returns are observed for all three measures, even when controlled for risk and for low priced stocks. But accounting earnings portfolios do not dominate working capital or cash flow portfolios. In fact, the raw returns to cash flow portfolios are marginally (statistically) larger than accounting earnings portfolios. Economically, a dollar invested in a portfolio using accounting earnings to select the stock would have an accumulated value of $22.73 while the same dollar investment using cash flow instead of accounting earnings would accumulate a value of $33.94 over the same 16 years starting with the second quarter of 1988 and concluding at the end of the first quarter of 2004. Thus, our results have implications for the studies of explanatory power of different measures of earnings and their comparison in the US and other markets.
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Notes
Francis et al. (2003).
In this study we also include working capital. For ease of exposition we will refer to accounting earnings and cash flow.
Similar to Basu’s study, Ou and Penman (1989a) provide evidence that excess market returns can be captured using public information. While their methodology is widely different from ours, their objective is not. They searched for a metric, more complex than ours, which yields abnormal returns. We compare very simple head to head metrics to ascertain whether these performance metrics differ in generating excess portfolio returns.
1988 is the first year in which cash flow reporting was required of all firms under FAS 95. As noted later in this study, the data collection period, as opposed to the financial reporting period, is lagged by 15 months. Since 1988 is the first year under FAS 95 and since the statements may not become public until 90 days later, we compute our first year of annual returns using the period April 1st, 1989 through March 31st, 1990). As a result, we collect data for the 16 year period, 1989–2005.
Returns for 1 and 6 months were also computed but are not reported since the conclusions are not affected.
We could compare the low to high but this would bias our results by overstating the advantage of our strategy. In addition, the comparison is not what investors would make. They seek to ‘pick’ firms that produce returns in excess of what firms not chosen earn. This is our design. The picked firms we denote as the portfolio. The firms not chosen we designate as the market.
One example of a criticism of the relevance of accounting accruals is Thomas (1975).
But the business community has learned only too painfully that all performance measures can and will be manipulated. WorldCom’s $5 billion overstatement in both earnings and operating cash flow was perpetrated by a simple reclassification of operating expenses as fixed asset investments. See Business Week (2004) for other examples of problems in earnings and operating cash flows.
As discussed earlier, stock prices and annual return data are collected on a 15 month lag basis over the period: 1989–2005. For example, earnings and cash flows that are reported in the 2003 financial statements are associated with the annual returns for the period 4/1/2004 through 3/31/2005.
We also studied 1 and 6 month returns. Our findings apply to these holding periods also.
The interested reader is referred to Bowen et al. (1987) for further details.
Size adjusted returns are computed using the Fama and French (1992) procedure.
We report returns for all deciles to guarantee that in fact our strategy is effective. That is, the returns should be declining and inversely related to the decile number. This is the case for all three performance measures and for the three holding periods.
A word of caution about Table 2 is appropriate: the data in the deciles are pooled across years so that while table is descriptively helpful, it is only an approximation of what will happen each year. A more accurate presentation would be to report deciles by year. However, the results would not change the basic pattern of relative returns by deciles.
For space limitations, the 1 and 6 month returns are not reported. Our comments and conclusions apply equally to them.
We use ‘weak’ to differentiate the actual behavior of returns versus what might be considered the ‘strong case’: one end of the distribution is negative while the other end is positive. In such a world, zero investment strategies would generate even greater returns.
For economy, we report results only for the annual returns and for PAE and PCFO. Our conclusions are not affected by these omissions.
We could alternatively estimate firm specific betas from the market model. The problem with this approach is that it would create a form of survivorship bias since many of our observations in both the portfolio and the market would have to be deleted for missing data. The Fama and French procedure avoids this problem.
The binomial probability is also 4%.
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Acknowledgments
We acknowledge the helpful comments from Professors Bill Baber, Steven Balsam, Jane Dillard-Eggers, Krishna Kumar, Wonsun Paek, Gnanakumar Visvanathan, Lucy Chen, and the participants at George Washington University workshop. We also acknowledge the helpful research assistance of Jong Eun Lee, Yinghong Zhang, Ki Song and Paige Gee. Professor Lipka acknowledges the summer research grant provided by Temple University.
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Kim, JB., Lipka, R. & Sami, H. Portfolio performance and accounting measures of earnings: an alternative look at usefulness. Rev Quant Finan Acc 38, 87–107 (2012). https://doi.org/10.1007/s11156-010-0220-1
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DOI: https://doi.org/10.1007/s11156-010-0220-1