Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns
- Ball, Gerakos, Linnainmaa and Nikolaev
- A version of the paper can be found here.
- Want a summary of academic papers with alpha? Check out our Academic Research Recap Category.
Accruals are the non-cash component of earnings. They represent adjustments made to cash flows to generate a profit measure largely unaffected by the timing of receipts and payments of cash. Prior research finds that expected returns increase in firm profitability. However, firms with high accruals generate lower returns than firms with low accruals, and this “accrual anomaly” strengthens when evaluated using asset pricing models that include a profitability factor. We show that a cash-based operating profitability measure (that excludes accruals) outperforms other measures of profitability (that include accruals) and subsumes accruals in predicting the cross section of average returns. The cash-based operating profitability measure explains expected returns over a ten year horizon, which is inconsistent with initial mispricing of earnings or its cash and accruals components.
Alpha Highlight:Accounting earnings appear to be a barometer of firm performance and are associated with future stock prices changes. An extensive body of literature has investigated various earnings-related signals, including gross profitability (Novy-Marx, 2013), operating profitability (Ball, 2014), etc. Gross profitability is under investigation from a lot of researchers. Some examples of research we’ve highlighted and discussed in the past:
Cash-based operating profitability (that removes accruals from operating profitability) subsumes the predictive ability of both accruals and profitability.
Key Findings:Operating profitability has two components: the cash component and the accruals component. Dechow (1994) pointed out that the role of accruals is “to facilitate the periodic measurement of firm performance”. Click to see the formulas. Finding 1: The cash component of profitability (i.e., the difference between operating profitability and accruals) outperforms operating profitability and subsumes accruals in predicting the cross section of expected returns. Specifically:
- Firms with high operating profitability and low accruals earn higher returns; however, the relationship is driven by the cash component.
- Consider the evidence from table below: “Operating profitability” and “Accruals” lost most of their predictive power when a “Cash-based operating profitability” factor is added.
- The “accrual anomaly” disappears once we control for cash-based operating profitability.
- That is to say, if firms are sorted based on cash-based operating profitability, an additional screen using accruals adds no predictive value.
- Below graph offers vivid evidence of this finding. It shows the cumulative returns on operating profitability, accruals, cash-based operating profitability, and the market from 1963 to 2013.
- This paper also finds that the predictive ability of cash-based operating profitability is robust and strong for up to ten years into the future.