Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?
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What they found
Sloan split reported earnings into the cash component and the accrual component (earnings that have not yet turned into cash) and showed that accruals are less persistent than cash flows, but that the market does not seem to appreciate this. Firms with high accruals subsequently underperformed and firms with low accruals outperformed, on U.S. stocks from 1962 to 1991, with a hedge portfolio earning about 10% per year. The pattern was concentrated around future earnings announcements, consistent with investors being surprised when accrual-heavy earnings failed to persist.
What you can use
- Earnings quality matters: profits backed by cash are more reliable than profits made of accounting accruals.
- The market underreacts to information that requires reading the cash flow statement, which is a durable edge for fundamentals-oriented traders.
- The effect has weakened since the 2000s as quantitative funds arbitraged it.
Caveats
Sample ends 1991; the anomaly diminished after publication and after Sarbanes-Oxley. Returns were concentrated in small stocks and are gross of costs.
Tags: anomalies, accruals, fundamentals, earnings
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.