Companies whose earnings are out of sync with the rest of their industry are more likely to misreport them.
Based on research Brian Rountree, James P. Weston and George Allayannis
Volatility In Cash Flow Can Create Strong Ripples In The Capital Market
- Investors pay a premium for firms with low cash-flow volatility.
- Investors don’t value earnings smoothed only through accruals. An accrual is a non-cash account that is used to recognize revenues/expenses in the same period as the transaction, even when cash flow does not occur in that period.
- Cash flow volatility affects firm investment decisions.
If money flows like a river, then investors prefer the waters calm. According to research authored by Brian Rountree and James P. Weston, both professors at Rice Business, investors put a premium on firms with smooth cash flows. But that premium does not extend to earnings that have been smoothed via accruals.
Using a large sample of non-financial firms, the researchers found that fluctuations in cash flows can create strong ripples in the capital market. A one percent increase in these fluctuations, known as volatility, corresponds to a 0.15 percent drop in a firm’s value. To understand the magnitude of this decrease, Rountree and Weston project an individual firm’s cash flow against the total sample. If individual firm’s cash flow volatility fell from the median to lower quartile amidst the sample the firm would see roughly an eight percent increase in value.
The authors also provide insight on how investors value the overall smoothness of earnings. Since earnings are made up of cash flows and accruals, volatility in earnings is affected by fluctuations in cash flows and by executive judgment through accruals. Past research has suggested that investors can’t discern whether firms obtain their smooth earnings through accruals or through low cash flow volatility. But Rountree's and Weston's study suggests that investors value smooth earnings only when they are achieved through lower cash-flow volatility.
One way in which managers smooth cash flows is through hedging with derivatives. In their analysis, Rountree and Weston found that using derivatives enhances firm value. They also showed that investors value smooth cash flows above and beyond the use of derivatives. These results suggest that other forms of managing cash-flow volatility are valuable to investors.
Lastly, the study indicates that investors are especially sensitive to cash-flow volatility in firms that rely heavily on external financing. This finding corroborates earlier research suggesting that cash-flow volatility can directly affect firm investment policy through the cost of capital.
James P. Weston is the Harmon Whittington Professor of Finance at Jones Graduate School of Business at Rice University and Brian Rountree is an associate professor of accounting at Jones Graduate School of Business at Rice University.
To learn more, please see: Rountree, B., Weston, J. P., & Allayannis, G. (2008). Do investors value smooth performance? Journal of Financial Economics, 90(3), 237-251.