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WHICH IS MORE VALUE RELEVANT: EARNINGS OR CASH FLOWS?

A LIFE CYCLE EXAMINATION

Ervin L. Black Department of Accounting University of Arkansas Fayetteville, AR 72701 Telephone: (501) 575-6118 Fax Number: (501) 575-7687 eblack@comp.uark.edu

May 1998

*This paper benefited from funding by the Cox Fellowship and the University of Washington Accounting Development Fund. I am grateful for comments on earlier drafts of the paper from dissertation committee members: Gary C. Biddle, Terry J. Shevlin, Edward Rice and Susan B. Moyer; seminar participants at the University of Arkansas, Michigan State University, University of Wyoming and Texas Christian University; and from Helen Adams, Robert Bowen, David Burgstahler, Kevin Harper, Alister Hunt, Lauren Kelly, Karen Pincus, D. Shores, and Kenton Walker.

WHICH IS MORE VALUE RELEVANT: EARNINGS OR CASH FLOWS? A LIFE CYCLE EXAMINATION

ABSTRACT: Statements in the financial press and recent research suggest that controversy exists as to which accounting measure is more value-relevant: earnings or cash flows. This study examines the relative value-relevance of earnings and cash flow measures in different life-cycle stages. Earnings are predicted to be more value-relevant in mature stages. Cash flows are expected to be more value relevant in stages characterized by growth and/or uncertainty. In general the hypotheses are supported using Wald X2 tests (Biddle, Seow, and Siegel 1995) of a model based on the theoretical work of Feltham and Ohson (1995). Evidence supports the hypothesis that earnings are more value-relevant than operating, investing, or financing cash flows in mature life-cycle stages. However, in the start-up stage investing cash flows are more value relevant than earnings. In growth and decline stages, operating cash flows are more value relevant than earnings.

WHICH IS MORE VALUE RELEVANT: EARNINGS OR CASH FLOWS? A LIFE CYCLE EXAMINATION

According to U. S. financial accounting standards and prior research, accrual-based earnings provide a better measure of firm performance than cash flow information. FASB Statement of Concepts No.1, paragraph 44, states: "information about enterprise earnings and its components measured by accrual accounting generally provides a better indication of enterprise performance than does information about current cash receipts and payments." Results from prior capital markets research imply that earnings are more value-relevant than operating cash flows (Dechow 1994; Biddle, Seow, and Siegel 1995; Rayburn 1986; Sloan 1996). However, an alternative view of accrual accounting is often expressed in the business press as illustrated in the Institutional Investor (August 1988, p. 55), "a growing number of portfolio managers and analysts insist that cash flows is a more meaningful measure of a company's value than reported earnings." Institutional Investor (1994) reports that 61.8 percent of chief financial officers make maximizing cash flow a top priority compared with 54 percent in a prior study.1 Also, even though Biddle, Seow, and Siegel (1995) find that in the majority of industries earnings is more value relevant than operating cash flows, in some industries operating cash flows is more value-relevant than earnings. Thus, there continues to be controversy as to which is more value relevant: earnings or cash flow measures. Prior research has not examined the effects of the corporate life cycle on the relative value-relevance of accounting performance measures. Bernard (1989) observes that, the primary deficiency of the existing [valuation] literature is that too little thought has been given to

what economic message could be conveyed by a given disclosure, and how that message may vary across situations. He also implies that a firms life-cycle stage could affect the valuerelevance of accounting disclosures when he states that it would be interesting to study how fundamental analysis for new firms differs from that for established firms. The Institute of Managerial Accountants (1986, p. 13) says that, at each stage...in an entity's life-cycle, different measures of financial performance take on varying degrees of importance. Therefore, neither growth nor net income nor cash flows nor return on investment [for example] should be emphasized to the exclusion of other meaningful measures. This paper addresses deficiencies of prior valuation/information content studies by addressing the question of whether earnings is more value relevant than cash flow measures in all firm life-cycle stages. The firm life cycle offers a key setting for analysis of the relative value-relevance of earnings and cash flow measures. The life-cycle concept captures a common set of financial characteristics for firms in a life-cycle stage and is used frequently in academic research and the financial press. Because a number of financial characteristics differ by lifecycle stage, it follows that the relative value-relevance of accounting measures may not be the same in each life-cycle stage. For example, cash flows may be more value-relevant than earnings for firms in decline. CA Magazine, (1993) p. 18-19, states that cash flow is a better measure of a companys recovery following a recession than are book profits. Also, one of the main reasons cited for business failures, especially for small start-up/emerging growth companies, is poor cash management, not lack of profits (Small Business Reports 1991). Hypotheses are developed which predict the relative value-relevance of the cash flow measures and earnings for firms in different life-cycle stages. These relationships are based on a

model of the components of firm value (Myers 1977). Financial characteristics associated with corporate life-cycle stages are used to classify firm-years into life-cycle stages. The relative value-relevance of earnings and three cash flow measures are tested cross-sectionally in lifecycle stage using methods developed in Biddle, Seow and Siegel (1995). Data are collected from various sources, including the Compustat Annual Industrial and the Annual Research data sources. As hypothesized earnings exhibit the strongest value-relevance for firms in mature stages. In the early and later life-cycle stages, a cash flow measure (investing cash flows in the startup and operating cash flows in the growth and decline stages) is more value-relevant than earnings. The results imply that for mature firms, earnings is a better summary measure than cash flows. But, in other life-cycle stages cash flow measures are better summary measures for valuation. Related Research on Life-Cycle Theory and Value-Relevance Corporate life-cycle theory is an extension of the product life-cycle concept developed in marketing and microeconomics (Rink and Swan 1979 and Mueller 1972). Individual products (goods or services) move through four more or less identifiable phases: start-up, growth, mature, and decline. Similarly, firms can be described as having life-cycle stages that depend on their portfolios of products. Models of the firm life cycle presuppose that there are regularities in corporate development and that these regularities occur in such a way that the corporations' developmental processes lend themselves to segmentation into stages or periods of time (Smith, Mitchell, and Summer 1985). Life-cycle stages are frequently used in the financial press and in investment research to describe firms. Secured Lender (1994), Network World (1994), Journal of Management (1994),

and Journal of Business Venturing (1994) provide evidence that businesses, investors, academics, and lenders use the life-cycle concept in their evaluations of firms. For example, the Secured Lender (1994, page 38) states that, an awareness of the clients specific growth stage and an understanding of where the firm has been and how it got there will help [lending institutions] better evaluate the firms financial information, current and future needs, and management capabilities. Also, various mutual fund companies have emerging growth or growth funds composed of firms that are primarily in the growth stage of the life-cycle. Prior research has not examined the effects of the corporate life cycle on the relative value-relevance of accounting performance measures. However, recent studies that examined the relative value-relevance of earnings and operating cash flows contain results that might be clarified by considering the corporate life cycle. For example, Dechow (1994) provides evidence that earnings are more value-relevant than operating cash flows (1) the shorter the performance measurement interval, (2) the greater the volatility of the firms working capital requirements and investment and financing activities, and (3) the longer the firms operating cycle. Her hypotheses are primarily based on the premise that cash flows are predicted to be more arbitrary and suffer more severely from timing and matching problems than earnings. This may be true for firms that are in the mature stage, but for firms that are in start-up, growth or decline, earnings also suffer from these problems. As another example, Biddle, Seow, and Siegel (1995) examine the relative valuerelevance of earnings, operating cash flows (CFO), and sales in different industries. They provide evidence that for most industries earnings are most value-relevant, but for some industries CFO is most value-relevant. While they did not attempt to control for industry life-

cycle, these results could be affected by the life-cycle stage of firms in a particular industry. As predicted by the hypotheses, cash flow measures of firms in industries with the majority of firms in start-up, growth, or decline stages may be expected to be more value-relevant than earnings. Moreover, there is some evidence of a life-cycle effect related to accounting measures other than earnings and cash flow measures. Anthony and Ramesh (1992) show that stock market response to unexpected sales growth and unexpected capital investment is a function of firm life-cycle stage, even after controlling for firm size, risk, and measurement error in the proxies of the performance measures. Black (1998) finds evidence of life-cycle impacts on the incremental information content of earnings and cash flow measures. Selling and Stickney (1989), in an examination of business environment effects on a firm's return on assets, find evidence that industry characteristics, including industry life-cycle, are useful in understanding return on assets (ROA) over time and across firms. For example, industries with the highest ROAs are all mature, whereas, industries with the lowest ROAs are either in the decline phase or highly cyclical. This study combines these life cycle and value-relevance research streams to examine the effect of the corporate life cycle on the value-relevance of accrual-based earnings and the three summary cash flow measures (FAS 95). In the next section hypotheses are developed which predict different relative value-relevance relationships for earnings and cash flow measures in different life-cycle stages. Life Cycle Effects on the Relative Value-Relevance of Accounting Measures Life Cycle Effects Consider the characterization of firm value provided by Myers (1977):

Value of Firm = Value of Assets in Place + Value of Growth Opportunities

(1)

The relative value of assets in place compared to the value of growth opportunities changes as a firm proceeds through its life-cycle. For example, start-up firm value is largely a function of the value of growth opportunities, whereas a mature firm has relatively fewer growth opportunities and its value is largely attributable to the value of assets in place. Myers characterization of firm value is closely related to a valuation model (used by Burgstahler and Dichev 1997 and Barth, Beaver and Landsman 1996) which expresses, in general form, market value of equity, MVE, for firm i in year t, as a linear function of recognized net assets (assets in place) measured by book value of equity - BVE, and unrecognized net assets (growth opportunities), UNA: MVEit = a1BVEit + a2UNAit (2)

If book values of recognized assets equal their fair values and fair values are well-defined as in a setting economically equivalent to perfect and complete markets, UNA equals the present value of incremental cash flows of unrecognized net assets (growth opportunities), and a 1 and a2 each equal one. If book values do not equal their fair values, then UNA also includes the difference between fair and book values of recognized net assets; i.e., it would include the value of the growth opportunities and the difference between fair and book values of assets. In the more realistic setting of imperfect and incomplete markets, UNA reflects the difference between assets values-in-use over entry or exit values, and a1 and a2 need not equal one. Because revenues and expenses relating to unrecognized net assets, including any excess of values-in-use over entry or exit values, can be reflected in net income (NI), net income is a proxy for UNA (see Bernard 1994; Barth and Landsman 1995, and Ohlson 1995). Depending on

a firms life-cycle stage other potential proxies of a firms unrecognized net assets are the three summary cash flow measures: operating cash flows (CFO), investing cash flows (CFI), and financing cash flows (CFF). The value-relevant information provided by a given accounting measure can be envisioned in a Venn diagram. Relative value-relevance tests compare the size of the circles to determine which is the largest.2 To empirically implement equation (2), the following estimating equation is used: MVEit = a0 + a2BVEit + a2UNAit + eit . Hypotheses are tested by comparing the value-relevance, in each life-cycle stage, of four different proxies of UNA: NI, CFO, CFI, and CFI. In his text, Stickney (1996, p. 46) shows the expected relation of income flows and cash flows from operations, investing, and financing at various life-cycle stages. White, Sondhi, and Fried (1997, pp. 187-188) describe life-cycle effects on the firms financial performance and the expected pattern of ratios in different life-cycle stages. Hypothesis Development: Life-cycle Effects on Relative Value-Relevance In early firm life-cycle stages, growth opportunities are a relatively larger component of firm value than assets in place. Assets in place, in these early stages, are expected to provide less value relevant information about firm value, because they are a relatively smaller component of firm value. In the start-up and early growth stages, book value of equity is expected to more closely approximate the liquidation value of assets in place; i.e., current cost is not too removed from historical cost. Thus, in these stages, the proxy that provides more value-relevant (3)

information about firm-value is the one that provides more information about the future growth opportunities of the firm. Cheung, Liu, and Schaefer (1996) find that the value-relevance of earnings decreases, and the value-relevance of operating cash flows increases, with a decrease in the permanence of earnings. In start-up and early growth stages, the revenue and expenses generated by a firms assets in place are expected to be more transitory than in later growth or mature stages, when income is more predictable. An example of this can be seen in the biotechnology or electronics industry when assets in place, used for development of products and research early in the firm life-cycle, generate few, if any, revenues, and income is negative. As these companies mature the nature of the revenues and expenses change to include more production and sales related activities, which become more predictable, and permanent, as the firm matures. Many firms fail during the early life-cycle stages for reasons related to cash flows. The cash flow measures are expected to provide information about the viability of the firm - whether the firm survives to realize its growth opportunities. Financing cash flows provide valuerelevant information about the ability of the firm to obtain financing to fund growth and development. Investing cash flows provide value relevant information about investment in longterm assets to develop growth opportunities or unrealized net assets, UNA. Operating cash flows provide information about the firms ability to internally fund growth. Thus, the first hypothesis is (in alternative form): H1: During early life-cycle stages, cash flow measures are expected to be more valuerelevant than earnings.

As the firm matures, growth opportunities, although still a major component of firm value, are relatively lower and the relative value of assets in place increases. Assets in place generate revenues and expenses which are more representative of the value-in-use, than in more early life-cycle stages. Also, the revenues and expenses generated by the assets in place are more value-relevant about the value of growth opportunities or UNA. More of the firms unrecognized net assets, or growth opportunities, are expected to be similar to its assets in place as firm expansion occurs in areas of business similar to its current business. Also, the firms ability to profitably take advantage of growth opportunities is better known as the firm develops a track record. In these later growth and mature stages, earnings are expected to be less transitory and more permanent. The clean surplus assumptions of the Feltham-Ohlson (1995) model are more likely to hold; thus, net income is also expected to better approximate UNA than in early or later life-cycle stages. Thus, in these stages, earnings are expected to provide more value-relevant information than cash flow measures, which yields the second hypothesis (in alternative form): H2: During mature life-cycle stages, earnings are expected to be more value-relevant than cash flow measures. In later, declining life-cycle stages the permanence of a firms earnings is expected to decline as the change in earnings is expected to be larger and negative for declining firms. Cheng, et.al., find evidence that supports the increased value-relevance of operating cash flows relative to earnings as the permanence of earnings declines. Barth, Beaver, and Landsman (1996) find that the value-relevance of net income is lower than book value of equity for firms with poor financial health relative to other firms. Subramanyan and Wild (1993) find that the

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informativeness of earnings is inversely related to proxies for probability of liquidation or financial difficulty. Thus, evidence suggests that earnings ability to convey value-relevant information about the firms unrecognized assets and/or the values-in-use over entry or exit values is lower when a firm is in decline. In contrast, cash flow measures are expected to provide value relevant information about the firms growth opportunities, or lack thereof. Operating cash flows provide information about the firms ability to continue to cover cash needs internally. Investing cash flows provide information about the liquidation value of a firms existing assets and about its capital expenditures. Financing cash flows provide value-relevant information about the firms financing activities, including its ability to borrow or repay debt and raise equity capital. Thus, the third hypothesis, in alternative form, is: H3: During declining life-cycle stages, cash flow measures are expected to be more value-relevant than earnings. Research Methodology Life-cycle stage classification This study reports results based on life-cycle classification methods developed by Anthony and Ramesh (1992). Anthony and Ramesh classify firms using individual variables (dividend payout, sales growth, and firm age) and then use a composite score obtained from all variables for classification. They assign firm-year observations into Low, Medium, or High categories for each of the three classification variables. Then, these rankings are assigned a score (1, 2, or 3). For each firm-year observation scores are then added to form a composite score and the observations are categorized into five life-cycle stages and assigned to groups such that an

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approximately equal number of observations are in each group: Growth, Growth/Mature, Mature, Mature/Decline, and Decline. In this paper, a start-up stage is also added composed of a smaller set of firm-years.3 The criteria for a start-up firm-year observation are the following: 1. Firm was founded between 1976 and 1994. 2. Firm was not formed as a result of a divestiture, merger, or other form of restructuring. 3. Firm had no more than one year of sales history prior to going public. 4. Only the first three years of firm data are included after the founding date. These firms, in their first three years, are classified as start-up firm-years. This classification assumes that the firm does not move into the growth stage any sooner than three years from inception. Relative value-relevance tests of the hypotheses are performed in each of six lifecycle stage portfolios. Sample Selection Data are obtained from Compustat (Annual and Research) 1976-1995 data sources for the financial statement variables and market values. Data for firm age is obtained from Moodys Industrial Manual. The sample is restricted to firms for which life-cycle classification data and cash flow and earnings data are available. Utilities, insurance, and financial institutions are not included in the study, due to their unique characteristics as regulated industries. The requirement for life-cycle classification data resulted in a potential sample size of 78,813 total firm-year observations. Required data for regression variables further reduced the sample to 37,961 firmyear observations: 192 Start-up observations 7,162 Growth observations

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7,350 Growth/Mature observations 6,169 Mature observations 8,514 Mature/Decline observations 8,574 Decline observations

Descriptive statistics (medians) are given in Table 1 for the firm-year observations in each of the life-cycle stages. These include the classification variables used in the multivariate classification and other firm characteristics. These descriptive statistics indicate that the classification method is successful, resulting in cross-sectional differences in firm characteristics across life-cycle stages. The start-up group has relatively low debt, negative earnings, operating cash flows, and investing cash flows. Start-up firms are smaller and younger than firms in other life-cycle groups, although their sales growth is high. The growth portfolio of firm-years exhibits positive earnings, operating cash flows and financing cash flows. The median growth firm pays few, if any dividends, investing cash flows are negative, and its debt is higher than a start-up firm. By construction the sales growth and capital expenditure ratios are largest for the growth portfolio and are lower in the other life-cycle portfolios. Growth firms are still relatively small compared to the mature firms. Firms in the growth/mature and mature portfolios are much larger and pay more dividends than in the earlier and later stages; debt is relatively high; net income and operating cash flows are positive, and investing and financing cash flows are negative. Firms in mature/decline and decline have lower earnings and operating cash flows (negative for decline firms); they are smaller, have less debt, have few financing cash flows or investing cash flows, and pay few dividends.

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Table 2 shows the industry composition of each of the life-cycle stage portfolios and Table 3 gives the number of firm-year observations by year for each of the life-cycle stages. From these tables it appears that there is some clustering of industry and years in the life-cycle stage portfolios. Clustering by industry is to be expected, because industries also have lifecycles that affect the firm life-cycle. Macroeconomic effects (business cycles) are also related to firm life-cycle and cause time clustering. However, the fact that firms start-up, for example, when economic conditions are favorable, or in promising industries, should not affect the relative value-relevance tests of accounting performance measures as long as these omitted variables are not correlated with the variables of interest. To substantiate the classification methodology and to make sure that random economic effects are not creating misclassification, a check is made on the stability of the firm-year classifications. If a firm-year observation is classified in a life-cycle stage portfolio, an examination is done one and two years prior to and after the year of classification to see in which life-cycle stage the firm is classified in those years. The start-up group, by construction, has no firm-year observations classified in other stages prior to the classification year. 60% of firms that are classified as start-up remained in the start-up group from one year to the next. Two years after being included in the start-up portfolio 79% of these firms are no longer in the start-up portfolio; 26% of the start-up firms are in the growth stage, none are in the mature stage, 31% are in the decline stage. The remainder of the start-up firms is not classified in a life-cycle stage portfolio within two years after being included in the start-up portfolio.

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A similar check of the other life-cycle stages indicates stability. For firm-years classified as growth firms in any year 51% are in the growth stage two years prior and 54% remained in the growth portfolio two years after being included in the growth portfolio. 67% of the mature firmyears are in the mature stage two years prior to being included in the mature portfolio and two years after inclusion 70% are still in the mature phase. 49% of the decline firm-years are in the decline stage two years prior to being included in the decline portfolio and two years after inclusion 64% are still in the decline phase. In Table 4, Pearson correlations of the regression coefficients are given. In the start-up stage there is some evidence of the collinearity of NI and CFO, as well as CFF with CFO and CFI. In the other life-cycle stages all of the variables are significantly correlated with each other. This indicates that these variables measure some of the same value relevant factors. The empirical tests are designed to determine which accounting performance measure is most value relevant in a particular life-cycle stage, regardless of overlap in information provided with other measures. Empirical Tests Tests of the relative value-relevance hypotheses are performed using Wald tests on the significance of the squared coefficients. Biddle, Seow, and Siegel (1995) develop a methodology for the problem of testing whether one subset of predictor variables is significantly more explanatory than another subset. This methodology is appropriate asymptotically when the disturbances could be heteroskedastic and assumes that the error terms, _i , from equations (4a-c) are vectors of unobserved random disturbances that are normally distributed with mean zero and unknown covariance matrix. Two different matrices represent subsets of predictor variables;
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each consists of a subset of columns of the independent variables. The object is to test whether one subset of predictor variables is significantly better than the other for the purpose of explaining the dependent variable, MVE. MVEit = 0+ 1BVEit + 2NIit + 3CFOit + _ 1it MVEit = 0+ 1BVEit + 2NIit + 3CFIit + _ 2it MVEit = 0+ 1BVEit + 2NIit + 3CFFit + _ 3it where, MVE = the market value of equity for firm i at time t. NI = earnings before extraordinary items for firm i at time t. CFO = cash flow from operating activities for firm i at time t. CFI = cash flow from investing activities for firm i at time t. CFF = cash flow from financing activities for firm i at time t. (4a) (4b) (4c)

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Null hypotheses for the relative value-relevance hypotheses become: Null Hypotheses NI =R CFO NI =R CFI NI =R CFF SUBSET 1 NI NI NI SUBSET 2 CFO CFF CFI EQUATION 4a 4b 4c

where, the sign, =R, signifies that each of the subsets of variables is equally value-relevant. In general when comparing the quality of two sets of predictors, X1 and X2 , the matrix Y1 consists of the columns of X that are not in X1 , and similarly for Y2. B1 and B2 are subsets (1 and 2, above) of regression coefficients for Y1 and Y2,, respectively. Thus, the null hypothesis becomes in general form: (equation 3.1 from Siegel & Biddle 1994) HO: B1Y1[In - X1(X1X1)-1 X1]Y1B1 = B2Y2[In - X2(X2X2)-1 X2]Y2B2 (5)

This nonlinear hypothesis is of quadratic form in the regression coefficients. The lefthand side of the hypothesis represents the bias due to omitting Y1 from the regression, keeping only X1, which is a quadratic form in the omitted regression coefficients B 1. The right-hand side represents the bias when Y2 is omitted. The test result is then computed using the estimated coefficients and their heteroskedasticity-adjusted variance-covariance matrix. Siegel and Biddle show that the Wald test is asymptotically valid and is appropriate when specific hypotheses are prespecified: as is the case in this paper. Appendix A shows the derivation of each of the tests of the relative value-relevance tests of the null hypotheses. These tests are performed for portfolios of firm-year observations that qualify for inclusion in one of the four life-cycle stages (start-up, growth, mature, and decline) and two transition stages (growth/mature and mature/decline).

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Results Results of the relative value-relevance tests are found in Tables 5 - 10. In general, the hypotheses are supported. The results provide evidence that cash flow measures are more valuerelevant than earnings in start-up, growth, and decline stages. Earnings are more value relevant in mature stages. In the start-up stage, the hypotheses predict that the cash flow measures are more valuerelevant than earnings. Evidence provided in Table 5 supports the hypothesis that investing cash flows are more value relevant than earnings for start-up firms. In the regression of equation 4b, CFI is the only significant independent variable and the Wald X2 statistic is significant. The Wald X2 statistic measures whether the information provided by one variable is significantly different from that provided by another. It does not, however, tell which measure has greater information. To do this, the R2 statistic is needed for regressions of equation 3, substituting the different independent variables for UNA. Table 5, Panel B, R2 statistics from regressions of equation 3 provide evidence that CFI (R2 = 0.33) is more value-relevant than earnings (R2 = 0.12). Neither operating nor financing cash flows is significantly more value-relevant than earnings, although the R2 statistics are higher for these variables than for earnings. In the growth stage, the hypotheses predict that the cash flow measures are more valuerelevant than earnings. Results for this stage are provided in Table 6. The results support the hypothesis that operating cash flows are more value relevant than earnings for growth firms. In the regression of equation 4a, CFO and BVE are incrementally significant, but not NI. The Wald X2 statistic is significant. The R2 statistics in Table 6, Panel B provide evidence that CFO (R2 =

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0.80) is more value-relevant than earnings (R 2 = 0.77). Neither investing nor financing cash flows is significantly more value-relevant than earnings. The hypotheses predict that earnings are more value-relevant than cash flow measures in the growth/mature stage. Results for this stage are provided in Table 7. The results provide evidence that earnings are more value-relevant than each of the cash flow measures for growth/mature firms. In the regression of equations 4a-c, NI is significant in each of the regressions. The operating and financing cash flow measures are only marginally significant, and investing cash flows are not significant. Wald X2 statistics are significant in each of the regressions. The R2 statistics in Table 7, Panel B provide evidence that NI (R 2 = 0.80) is more value-relevant than CFO (R2 = 0.75), CFI (R2 = 0.75), or CFF (R2 = 0.74). The hypotheses predict that earnings are more value-relevant than cash flow measures in the mature stage. The results, Table 8, provide evidence that earnings are more value-relevant than each of the cash flow measures for mature firms. NI is significant in each of the regressions of equations 4a-c. Operating and investing cash flow measures are incrementally significant, but financing cash flows are only marginally significant. Wald X2 statistics are significant in each of the regressions. The R2 statistics in Table 8, Panel B provide evidence that NI (R 2 = 0.87) is more value-relevant than CFO (R2 = 0.82), CFI (R2 = 0.81), or CFF (R2 = 0.79). The hypotheses predict that earnings are more value-relevant than cash flow measures in the mature/decline stage. However, results, shown in Table 9, provide evidence that operating cash flows are more value-relevant than earnings. Earnings, also, do not appear to be more value-relevant than investing or financing cash flow measures for mature/decline firms. NI is incrementally significant only in the regression of equation 4a. Operating and investing cash

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flow measures are incrementally significant, but financing cash flows are not significant. Wald X2 statistics are significant only in equation 4a. The R2 statistics in Table 9, Panel B provide evidence that CFO (R2 = 0.80) is more value-relevant than NI (R2 = 0.76). For CFI (R2 = 0.78) and CFF (R2 = 0.76) the evidence suggests that the value-relevance of these measures of cash flow is at least as good as the value-relevance of earnings for firms in the mature/decline stage. In the decline stage, the hypotheses predict that cash flow measures are more valuerelevant than earnings. Table 10 provides results that support the hypothesis that operating cash flows are more value-relevant than earnings. CFO, but not NI, is incrementally significant in the regression of equation 4a. Wald X2 statistics are significant only in equation 4a. The R2 statistics in Table 10, Panel B provide evidence that CFO (R2 = 0.48) is more value-relevant than NI (R2 = 0.39). For CFI (R2 = 0.38) and CFF (R2 = 0.37) the evidence suggests that the value-relevance of these measures of cash flow is no better than the value-relevance of earnings for firms in the decline stage. Although not tested directly, the explanatory power of the models appear to be much better in the growth, growth/mature, mature, and mature/decline stages. The R2 statistics of the regressions in these stages was on the order of 0.80, while in the start-up and decline stages the R2 statistics are much lower (0.12 to 0.33 for start-up and 0.37 to 0.48 for decline portfolios). From these results it seems that information other than earnings and cash flows is being used to determine market values, e.g., intangibles, human capital, probability of bankruptcy, etc. There is also evidence that the size of the coefficients is different depending on the lifecycle stage. The earnings coefficient in the growth/mature and mature stages are much larger than in other life-cycle stages. These mature stages are also the stages when earnings dominate

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the cash flow measures. In the other stages (start-up, growth, and decline), the earnings coefficient is very small and earnings do not tend to be significant in the regressions.

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Conclusions and Implications Much of the valuation/information content research in accounting has been devoted to verifying the value-relevance/informativeness of earnings beyond the more primitive cash flow measures, particularly operating cash flows. This study examines the relative value-relevance of not only earnings and operating cash flows, but also examines investing and financing cash flows. Also, by examining the effects of the corporate life-cycle on these relationships, this study is able to provide evidence of the value-relevance of earnings and cash flow measures in the economic context of life-cycle theory. The results of this study suggest that life-cycle stages influence the value-relevance of earnings and cash flow measures. The results provide evidence that earnings are more useful than cash flow measures only in the growth/mature and mature stages. The relative value-relevance test results provide evidence that the accrual process, which yields earnings, gives more value-relevant information than operating cash flows in the growth/mature and mature life-cycle stages. Earnings are also more value-relevant than investing and financing cash flows in these two stages. Only about one-third of the observations are in this stage. For firms in early and later life cycle stages (about two-thirds of the observations), cash flow measures are more value relevant, although the particular cash flow measure differs. Investing cash flows are more value-relevant than earnings in the start-up stage, and operating cash flows are more value relevant than earnings in the growth, mature/decline, and decline stages. In start-up, growth, mature/decline, and decline life-cycle stages, the evidence suggests that cash flow measures are at least as value-relevant as earnings, which supports the usefulness of the cash flow statement, provided for in FAS 95. This evidence implies that in the early and

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later life-cycle stages of the firm earnings may not be the summary measure that investors and creditors should focus on. Earnings do not dominate the cash flow measures in these early and later stages when growth is occurring or when the long-term viability of the firm is in question. Implications of this study apply to researchers, analysts, educators, and firm management. Results will be weaker, and may lead to inaccurate conclusions, if researchers on the value-relevance of accounting and non-accounting disclosures assume that these disclosures are equally value-relevant in all life-cycle stages. Analysts need to be aware of the changing value-relevance of these and other accounting measures throughout the life cycle. Educators and most textbooks, in general discuss the statement of cash flows last and do not give it the emphasis that it needs given the results of this study. Also, firm management need not focus, nor be evaluated, on earnings as the most value-relevant accounting number in all life-cycle stages of the firm. A subject for future study is the examination of the value-relevance of other accounting variables in life-cycle stages, particularly for start-up and decline firms, when the R2 statistics are much lower. This study provides evidence that accounting performance measures (earnings and cash flow variables) have limited usefulness in these stages. Therefore, other accounting variables can be examined for informativeness, such as research and development expenditures and other intangibles, such as access to technology and human capital. A call has been made for this line of research (Lev 1997). Examining firms in these early and late life-cycle stages can enhance the potential for powerful results.

23

ENDNOTES
1

Other examples in the business press include: Cash is king, Small Business Reports 1991, pp. 48-56; Cash is king for corporate Japan, Business Week 1995, p. 37; Where cash flow is king, The Economist 1995, p. 80.
2

Incremental value-relevance is concerned with the overlap of the circles. For example, if the information from earnings is in circle A, and the information from one of the cash flow measures is in circle B, circles A and B can overlap to some extent and both may be incremental to the other unless the circles are coincidental. But, tests of incremental informativeness or valuerelevance do not test for which circle is larger the other. For a more extensive discussion on relative vs. incremental information content see Biddle, Seow, and Siegel (1995).
3

Despite the fact that the great majority of firms on Compustat and CRSP are in later life-cycle stages, a sample of 192 firm-years is obtained for the start-up group. Mikkelson and Shah (1993) in a study of IPO firms, found a substantial number of firms (52) during the 1980 - 83 time period, which had gone public, had data available on Compustat, and had no more than one year of sales history. They provided me with a listing of these firms. I have also been able to use an IPO database provided by Jay Ritter to get some of the stock return data for these firms. Data from these sources are supplemented with data obtained from Compustat, CRSP, Moodys Industrial manual, and annual reports to complete the data requirements for firms, which meet the criteria for start-ups. This group consists of over a hundred firms that have data on Compustat or in annual reports.

24

REFERENCES Anthony, J.H. and K. Ramesh, Association between accounting performance measures and stock prices: A test of the life-cycle hypothesis, Journal of Accounting and Economics 15, 1992, 203-227. Barth, M.E., W.H. Beaver, and W.R. Landsman, Valuation characteristics of equity book value and net income: Tests of the abandonment option hypothesis, 1996, Working Paper, Stanford University. Bernard, V., Accounting-based valuation methods, determinants of market-to-book ratios, and implications for financial statement analysis, 1994, Working paper, University of Michigan. ________, Capital markets research in accounting during the 1980's: A critical review, Excerpt from: The State of Accounting Research As We Enter the 1990's , 1989, Thomas Frecka, Editor, University of Illinois, 72-120. Biddle, G.C., G.S. Seow, and A. Siegel, Relative versus incremental information content, Contemporary Accounting Research 12 (Summer 1995): 1-23. Black, E. L., Life-Cycle Impacts on the Incremental Value-Relevance of Earnings and Cash Flow measures, 1998, Working Paper, University of Arkansas, Fayetteville, Arkansas. Bowen, R.M., D. Burgstahler, and L.A. Daley, The incremental information content of accrual versus cash flows, The Accounting Review 62, 1987, 723-747. Burgstahler, D.C. and I.D. Dichev, Earnings, adaptation, and equity value. The Accounting Review 72, 1997, 187-215. Cash is king for corporate Japan, Business Week (May 1, 1995), 37. Cheng, C. S. A, C. S. Liu, and T. S. Schaefer, Earnings permanence and the incremental information content of cash flows from operations, Journal of Accounting Research 34 (Spring 1996), 173-81. Companies in convalescence, CA Magazine (April 1993), 18-19. Csenger, M. and S. MacAskill, Venture capitalists sow the seeds of future nets, Network World 11, 1994, 1 and 10. Cheng, C.S., C. Liu, and T.F. Shaefer, Earnings permanence and the incremental information content of cash flows from operations, Journal of Accounting Research (Spring 1996), 173-181.

25

Gopinath, C., Bank strategies toward firms in decline, Journal of Business Venturing 10, 1994, 75-92. Dechow, P., Accounting earnings and cash flows as measures of firm performance: The role of accounting accruals, Journal of Accounting and Economics 18, 1994, 3-42. Feltham, G. and J. Ohlson, Valuation and clean surplus accounting for operating and financial activities, Contemporary Accounting Research 11, 1995, 689-731. Financial Accounting Standards Board, Statement of financial accounting concepts No. 1: Objectives of financial reporting by business enterprises, 1978, Stamford, CT: FASB. Financial Accounting Standards Board, Statement of financial accounting standards No. 95: Statement of cash flows, 1987, Stamford, CT: FASB. Gardner, L.A., Opportunities and pitfalls in financing during business growth, Secured Lender 50, Issue 3, 1994, 38-42. Institute of Managerial Accountants, Statements on management accounting, Statement no. 4D, Measuring entity performance (January 1986), IMA, Montvale, NJ. King cash, Institutional Investor (September 1994), 203. Lant, J., Cash is king, Small Business Reports (May 1991), 48-56. Lev, B., On the usefulness of earnings and earnings research: lessons form two decades of empirical research, Journal of Accounting Research, (Supplement 1989), 153-192. _____, Announcing the foundation of the Intangibles Research Center at the Vincent C. Ross Institute of Accounting Research, Accounting Horizons (March 1997), 136-138. Mikkelson, W.H., and K. Shah, Going public and operating performance, 1993 Working Paper, University of Oregon. Mueller, D.C., A life-cycle theory of the firm, Journal of Industrial Economics 20, 1972, 199219. Myers, S.C., Determinants of corporate borrowing, Journal of Financial Economics 5, 1977, 147-175. Ohlson, J., Earnings, book values and dividends in security valuation. Contemporary Accounting Research 11, 1995, 661-687.

26

Pashley, M.M., and G.C. Philipattos, Voluntary divestitures and corporate life cycle: some empirical evidence, Applied Economics 22, 1990, 1181-1196. Rayburn, J., The association of operating cash flow and accruals with security returns, Journal of Accounting Research 24, (Supplement 1986), 112-137. Rink, D.R. and J.E. Swan, Product life-cycle research: A literature review, Journal of Business Research, 1979, 219-247. Selling, T.I. and C.P. Stickney, The effects of business environment and strategy on a firm's rate of return on assets, Financial Analysts Journal , 1989, 43-52. Sheppard, J.P., Strategy and bankruptcy: An exploration into organizational death, Journal of Management 20, 1994, 795-833. Siegel, A.F. and G.C. Biddle, Comparison of regression functions in the presence of heteroskedasticity, 1994, Working Paper, University of Washington. Sloan, R.G., Do stock prices fully reflect information in accruals and cash flows about future earnings?, The Accounting Review 71, 1996, 289-315. Smith, K.G., T.R. Mitchell, and C.E. Summer, Top level management priorities in different stages of the organizational life-cycle, Academy of Management Journal 28, 1985, 799-820. Stickney, C.P, Financial Statement Analysis A Strategic Perspective, 1996, Third Edition, Dryden Press, Fort Worth, TX. Subramanyam, K.R., and J.J. Wild, The going concern assumption and the informativeness of earnings, 1993, Working Paper, University of Wisconsin, Madison, WI. Where cash flow is king, The Economist, 334 (February 18, 1985), 80. White, G.I., A.C. Sondhi, and D.Fried, The Analysis and Use of Financial Statements, 1997, Second Edition, John Wiley & Sons, NY, NY.

27

Table 1 Descriptive Statistics by Life-Cycle Stage (Medians) # Observations Variable Market Value of Equity Book Value of Equity Net Income Cash Flow from Operations Cash Flow from Investing Cash Flow from Financing Sales Growth (%) Capital Expenditure Ratio Capital Expenditures Dividend Payout Ratio Size (Total Assets) Debt to Equity Ratio Firm Age 192 Start-up 16.52 3.40 -0.29 -0.60 -0.83 1.93 27.21 0.09 0.29 0 5.05 0.06 2.36 7,162 Growth 7,350 Growth/ Mature 21.95 164.19 12.16 0.66 0.89 -3.88 1.86 38.32 0.13 4.21 0 29.97 0.42 16.48 115.13 14.76 20.18 -21.90 -0.31 12.30 0.10 21.80 0.33 269.59 0.57 24.43 6,169 Mature 8,514 Mature/ Decline 208.47 24.64 128.84 16.15 22.06 -19.37 -1.57 8.29 0.07 3.95 0.36 282.62 0.49 33.51 13.73 0.16 0.91 -1.19 0 6.16 0.04 1.14 0 33.86 0.30 38.64 8,574 Decline 10.91 4.41 -0.52 -0.02 -0.163 0 -13.24 0.02 0.22 0 12.52 0.16 43.65

Definition of Variables: Market value of equity (in $millions), shares outstanding X fiscal year closing price (d25*d199). Book value of equity (in $millions), d60. Net income before extraordinary items and discontinued operations (in $millions), d18. Cash flow from operating activities (in $millions), Compustat d308 for years 1987-1993; prior to 1987, CFO is calculated as: d18 net income before extraord. items and discontinued operations + d14 Depreciation and amortization (0 if missing) + d5 Change in total current liabilities d34 Change in current debt (0 if missing) d4 Change in total current assets + d1 Change in cash & cash equivalents (0 if #1 missing) + d74 Change in balance sheet deferred taxes (#50, income statement deferred taxes, if missing. 0 if both missing).

28

Cash flow from financing activities (in $millions), Compustat d313 for years 1987-1993; prior to 1987, CFF is calculated as: d9 Total long term debt + d130 Preferred stock - carrying value (0 if missing) + d85 Common Stock + d210 Capital Surplus d127 Cash Dividends (0 if missing). Cash flow from financing activities (in $millions), Compustat d313 for years 1987-1993; prior to 1987, CFI is calculated as: Change in Cash (d162) - CFF - CFO. Sales Growth = [(SALESt - SALESt-1 ) / SALES t-1 ] X 100. (SALES = d12) Capital Expenditure Ratio = (CEt /Book Valuet ) X 100. (CE = d128; VALUE = d60) Capital Expenditures (d128). Dividend Payout Ratio is DIVt / NI t * 100, where, DIV = Annual Dividend (d127); NI = Annual Net Income (d18). Size is total assets (in $millions), defined as Compustat d6. Debt to equity ratio defined as Compustat (d181 - d5)/d216. Firm Age is the age of the firm, computed as the difference between the current year and the year the business was incorporated, except for the start-up sample, which is the difference between the current year and the first year the company reported sales.

29

Table 2 Industry Composition by Life-Cycle Stage


Industry Startup Growth G/M Mature M/D Decline Total

00-09 Agriculture & Const. Matl 10-14 Mining, Oil & Gas 15-19 Construction 20-22 Consumer Goods & Food 23-25 Apparel 26-27 Business Sup., Printing, & Publishing 28 Pharmaceuticals & Chemicals 29 - Oil and Gas Refineries & Retail 30 Rubber & Plastic 31-33 Manufactured Prods: Steel, Const. Matl, & Clothing 34 Fabricated Prods 35 Machinery 36 Electrical Eq. 37 Autos, Rail, Ships & Aircraft 38-39 Medical, Measurg & Control Eq 50-59 Wholesale & Retail 70-89 Restaur., Lodging, Computers, Bus. & Pers. Services 90-99 Other Totals by Life-Cycle Stage

0 2 0 0 0 4 15 0 2 6

41 1452* 94 238 149 161 283 31 162 191

30 303 117 689* 329 581* 469 195* 242* 421*

36 310 108 476* 298 408* 556* 163* 159* 376*

56 748* 159* 211 325 155 823* 21 133 218

61 216 108 585* 417* 301 336 60 108 686*

224 3031 586 2199 1518 1610 2482 470 806 1898

3 29* 12 7 21 37 52*

167 656 789* 163 514 1157 883*

335* 644 479 339* 489 1217 465

283* 553 432 269* 491 875 374

215 1012* 979* 184 1114* 993 1076*

385* 935* 749 265 580 2237* 541

1388 3829 3440 1227 3209 6516 3391

2 192

31 7162

6 7350

2 6169

92* 8514

4 8574

137 37961

An asterisk (*) indicates a significant X 2 where observations were significantly greater than the overall distribution.

30

Table 3 Firm-Year Observations for Each Year by Life-Cycle Stage


Year Start-up Growth Growth/ Mature Mature Mature/ Decline Decline Total by Year

1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 Total

1 1 2 3 11 26* 32* 26* 27* 19* 15 13 3 4 2 4 3 0 0 192

220 243 272 229 439* 303 333 628* 338 348 577* 494* 384 434 244 282 343 564* 487* 7162

627* 601* 574* 515* 529* 384 415 510* 333 298 359 353 313 308 191 206 245 330 259 7350

346* 296* 304* 383* 344 372 367 296 353 309 305 332 296 317 280 294 296 363 316 6169

149 152 175 205 260 398 396 324 497 491* 482 446 513 512 674* 726* 753* 681* 680* 8514

269 245 315 548* 424 671* 577* 353 554* 447 341 377 671* 707* 872* 813* 109 147 134 8574

1612 1538 1642 1883 2007 2154 2120 2137 2102 1912 2079 2015 2180 2282 2263 2325 1749 2085 1876 37961

An asterisk (*) indicates a significant X 2 where observations were significantly greater than the overall distribution.

31

Table 4 Regression Variable Correlations by Life-Cycle Stage A. Start-up


MVE 0.17 -0.05 -0.04 -0.29 0.09 BVE -0.02 -0.04 -0.19 0.03 NI CFO CFI

BVE NI CFO CFI CFF

0.29 -0.03 -0.13

-0.01 -0.64

-0.38

B. Growth
MVE 0.89 0.60 0.77 -0.61 0.39 BVE 0.69 0.77 -0.59 0.39 NI CFO CFI

BVE NI CFO CFI CFF

0.60 -0.23 0.05

0.34 -0.68

-0.88

C. Growth/Mature
MVE 0.87 0.88 0.83 -0.79 -0.20 BVE 0.90 0.93 -0.87 -0.24 NI CFO CFI

BVE NI CFO CFI CFF

0.92 -0.84 -0.29

-0.33 -0.89

0.10

D. Mature
MVE 0.89 0.92 0.90 -0.80 -0.14 BVE 0.92 0.93 -0.80 -0.23 NI CFO CFI

BVE NI CFO CFI CFF

0.92 -0.79 -0.20

-0.86 -0.23

-0.27

Bold indicates significance at the 0.05 level.

32

Table 4 Regression Variable Correlations by Life-Cycle Stage (continued)

E. Mature/Decline
MVE 0.88 -0.11 0.79 -0.67 0.12 BVE -0.14 0.76 -0.64 0.13 NI CFO CFI

BVE NI CFO CFI CFF

-0.42 0.15 0.19

-0.78 0.04

-0.62

F. Decline
MVE 0.68 0.41 0.52 -0.23 -0.02 BVE 0.46 0.38 -0.18 -0.03 NI CFO CFI

BVE NI CFO CFI CFF

0.42 -0.28 0.02

-0.48 0.20

-0.61

Bold indicates significance at Th 0.05 level.

33

Table 5 Results of Relative Value Relevance of Earnings and Cash Flows - START-UP MVEit = 0+ 1BVEit + 2NIit + 3CFOit + _ 1it MVEit = 0+ 1BVEit + 2NIit + 3CFIit + _ 2it MVEit = 0+ 1BVEit + 2NIit + 3CFFit + _ 3it Panel A: Regression Results Equation Regression Variable 4a (CFO) Coefficient Estimate -10.25* 0.74 -0.59 -1.22 CFI CFF Wald X2 Statistic 0.003 p-value = 0.95 3.69 p-value = 0.05 -0.35* 0.36 0.521 p-value = 0.47 4b (CFI) Coefficient Estimate -12.46* 0.87 -0.44 4c (CFF) Coefficient Estimate -9.32* 0.99 -0.75 (4a) (4b) (4c)

Intercept BVE NI CFO

*Significant at the 5 percent level.

34

Table 5 (continued)

MVEit = a0 + a2BVEit + a2UNAit + eit . Panel B: R2 Results of Regressions of Equation (3). CFO Hypothesis Test NI >R CFO CFO >R NI NI >R CFI CFI CFI > R NI NI >R CFF CFF

(3)

CFF >R NI

Prediction

NO

YES

NO

YES

NO

YES

R2 of Equation (3) with different variables representing UNA

NI: CFO:

R2 = 0.12 R2 = 0.15

NI: CFI:

R2 = 0.12 R2 = 0.33

NI: CFF:

R2 = 0.12 R2 = 0.20

MVE = the market value of equity for firm i at time t. BVE = the book value of equity for firm i at time t. UNA = the unrealized net assets of firm i at time t (proxies used are NI, CFO, CFI, & CFF). NI = earnings before extraordinary items for firm i at time t. CFO = cash flow from operating activities for firm i at time t. CFI = cash flow from investing activities for firm i at time t. CFF = cash flow from financing activities for firm i at time t.

35

Table 6 Results of Relative Value Relevance of Earnings and Cash Flows - GROWTH MVEit = 0+ 1BVEit + 2NIit + 3CFOit + _ 1it MVEit = 0+ 1BVEit + 2NIit + 3CFIit + _ 2it MVEit = 0+ 1BVEit + 2NIit + 3CFFit + _ 3it Panel A: Regression Results Equation Regression Variable 4a (CFO) Coefficient Estimate 26.78* 1.29* -0.51 1.80* CFI CFF Wald X2 Statistic 3.26 p-value = 0.05 0.90 p-value = 0.34 -0.49* 0.28 0.28 p-value = 0.60 4b (CFI) Coefficient Estimate 24.59* 1.40* 0.43 4c (CFF) Coefficient Estimate 26.56* 1.52* 0.27 (4a) (4b) (4c)

Intercept BVE NI CFO

*Significant at the 5 percent level.

36

Table 6 (continued)

MVEit = a0 + a2BVEit + a2UNAit + eit . Panel B: R2 Results of Regressions of Equation (3). CFO Hypothesis Test NI >R CFO CFO >R NI NI >R CFI CFI CFI > R NI NI >R CFF CFF

(3)

CFF >R NI

Prediction

NO

YES

NO

YES

NO

YES

R2 of Equation (3) with different variables representing UNA

NI: CFO:

R2 = 0.77 R2 = 0.80

NI: CFI:

R2 = 0.77 R2 = 0.78

NI: CFF:

R2 = 0.77 R2 = 0.77

MVE = the market value of equity for firm i at time t. BVE = the book value of equity for firm i at time t. UNA = the unrealized net assets of firm i at time t (proxies used are NI, CFO, CFI, & CFF). NI = earnings before extraordinary items for firm i at time t. CFO = cash flow from operating activities for firm i at time t. CFI = cash flow from investing activities for firm i at time t. CFF = cash flow from financing activities for firm i at time t.

37

Table 7

Results of Relative Value Relevance of Earnings and Cash Flows GROWTH/MATURE MVEit = 0+ 1BVEit + 2NIit + 3CFOit + _ 1it MVEit = 0+ 1BVEit + 2NIit + 3CFIit + _ 2it MVEit = 0+ 1BVEit + 2NIit + 3CFFit + _ 3it (4a) (4b) (4c)

Panel A: Regression Results Equation Regression Variable 4a (CFO) Coefficient Estimate 2.34 0.81* 7.60* -0.96** CFI CFF Wald X2 Statistic 8.46 p-value = 0.01 8.44 p-value = 0.01 -0.20 0.72** 9.17 p-value = 0.01 4b (CFI) Coefficient Estimate 7.54 0.63* 6.57* 4c (CFF) Coefficient Estimate -8.15 0.66* 6.91*

Intercept BVE NI CFO

*Significant at the 5 percent level. **Significant at the 10 percent level.

38

Table 7 (continued)

MVEit = a0 + a2BVEit + a2UNAit + eit . Panel B: R2 Results of Regressions of Equation (3). CFO Hypothesis Test NI >R CFO CFO >R NI NI >R CFI CFI CFI > R NI NI >R CFF CFF

(3)

CFF >R NI

Prediction

YES

NO

YES

NO

YES

NO

R2 of Equation (3) with different variables representing UNA

NI: CFO:

R2 = 0.80 R2 = 0.75

NI: CFI:

R2 = 0.80 R2 = 0.75

NI: CFF:

R2 = 0.80 R2 = 0.74

MVE = the market value of equity for firm i at time t. BVE = the book value of equity for firm i at time t. UNA = the unrealized net assets of firm i at time t (proxies used are NI, CFO, CFI, & CFF). NI = earnings before extraordinary items for firm i at time t. CFO = cash flow from operating activities for firm i at time t. CFI = cash flow from investing activities for firm i at time t. CFF = cash flow from financing activities for firm i at time t.

39

Table 8

Results of Relative Value Relevance of Earnings and Cash Flows - MATURE MVEit = 0+ 1BVEit + 2NIit + 3CFOit + _ 1it MVEit = 0+ 1BVEit + 2NIit + 3CFIit + _ 2it MVEit = 0+ 1BVEit + 2NIit + 3CFFit + _ 3it Panel A: Regression Results Equation Regression Variable 4a (CFO) Coefficient Estimate 13.30 0.22 9.34* 1.45* CFI CFF Wald X2 Statistic 7.66 p-value = 0.01 11.77 p-value = 0.01 -0.97* 0.83** 19.62 p-value = 0.01 4b (CFI) Coefficient Estimate -1.83 0.33* 9.92* 4c (CFF) Coefficient Estimate -16.90 0.50* 10.69* (4a) (4b) (4c)

Intercept BVE NI CFO

*Significant at the 5 percent level. **Significant at the 10 percent level.

40

Table 8 (continued)

MVEit = a0 + a2BVEit + a2UNAit + eit . Panel B: R2 Results of Regressions of Equation (3). CFO Hypothesis Test NI >R CFO CFO >R NI NI >R CFI CFI CFI > R NI NI >R CFF CFF

(3)

CFF >R NI

Prediction

YES

NO

YES

NO

YES

NO

R2 of Equation (3) with different variables representing UNA

NI: CFO:

R2 = 0.87 R2 = 0.82

NI: CFI:

R2 = 0.87 R2 = 0.81

NI: CFF:

R2 = 0.87 R2 = 0.79

MVE = the market value of equity for firm i at time t. BVE = the book value of equity for firm i at time t. UNA = the unrealized net assets of firm i at time t (proxies used are NI, CFO, CFI, & CFF). NI = earnings before extraordinary items for firm i at time t. CFO = cash flow from operating activities for firm i at time t. CFI = cash flow from investing activities for firm i at time t. CFF = cash flow from financing activities for firm i at time t.

41

Table 9

Results of Relative Value Relevance of Earnings and Cash Flows MATURE/DECLINE MVEit = 0+ 1BVEit + 2NIit + 3CFOit + _ 1it MVEit = 0+ 1BVEit + 2NIit + 3CFIit + _ 2it MVEit = 0+ 1BVEit + 2NIit + 3CFFit + _ 3it (4a) (4b) (4c)

Panel A: Regression Results Equation Regression Variable 4a (CFO) Coefficient Estimate 71.41* 1.05* 0.75* 2.50* CFI CFF Wald X2 Statistic 15.55 p-value = 0.01 1.95 p-value = 0.16 -1.07* 0.09 0.11 p-value = 0.74 4b (CFI) Coefficient Estimate 74.16* 1.28* -0.25 4c (CFF) Coefficient Estimate 73.48* 1.47* -0.31

Intercept BVE NI CFO

*Significant at the 5 percent level. **Significant at the 10 percent level.

42

Table 9 (continued)

MVEit = a0 + a2BVEit + a2UNAit + eit . Panel B: R2 Results of Regressions of Equation (3). CFO Hypothesis Test NI >R CFO CFO >R NI NI >R CFI CFI CFI > R NI NI >R CFF CFF

(3)

CFF >R NI

Prediction

YES

NO

YES

NO

YES

NO

R2 of Equation (3) with different variables representing UNA

NI: CFO:

R2 = 0.76 R2 = 0.80

NI: CFI:

R2 = 0.76 R2 = 0.78

NI: CFF:

R2 = 0.76 R2 = 0.76

MVE = the market value of equity for firm i at time t. BVE = the book value of equity for firm i at time t. UNA = the unrealized net assets of firm i at time t (proxies used are NI, CFO, CFI, & CFF). NI = earnings before extraordinary items for firm i at time t. CFO = cash flow from operating activities for firm i at time t. CFI = cash flow from investing activities for firm i at time t. CFF = cash flow from financing activities for firm i at time t.

43

Table 10

Results of Relative Value Relevance of Earnings and Cash Flows - DECLINE MVEit = 0+ 1BVEit + 2NIit + 3CFOit + _ 1it MVEit = 0+ 1BVEit + 2NIit + 3CFIit + _ 2it MVEit = 0+ 1BVEit + 2NIit + 3CFFit + _ 3it (4a) (4b) (4c)

Panel A: Regression Results Equation Regression Variable 4a (CFO) Coefficient Estimate 30.07* 1.16* 0.59 2.91* CFI CFF Wald X2 Statistic 5.68 p-value = 0.02 0.19 p-value = 0.66 -0.67* 0.31 0.63 p-value = 0.43 4b (CFI) Coefficient Estimate 37.39* 1.31* 1.44** 4c (CFF) Coefficient Estimate 38.35* 1.35* 1.64*

Intercept BVE NI CFO

*Significant at the 5 percent level. **Significant at the 10 percent level.

44

Table 10 (continued)

MVEit = a0 + a2BVEit + a2UNAit + eit . Panel B: R2 Results of Regressions of Equation (3). CFO Hypothesis Test NI >R CFO CFO >R NI NI >R CFI CFI CFI > R NI NI >R CFF CFF

(3)

CFF >R NI

Prediction

NO

YES

NO

YES

NO

YES

R2 of Equation (3) with different variables representing UNA

NI: CFO:

R2 = 0.39 R2 = 0.48

NI: CFI:

R2 = 0.39 R2 = 0.38

NI: CFF:

R2 = 0.39 R2 = 0.37

MVE = the market value of equity for firm i at time t. BVE = the book value of equity for firm i at time t. UNA = the unrealized net assets of firm i at time t (proxies used are NI, CFO, CFI, & CFF). NI = earnings before extraordinary items for firm i at time t. CFO = cash flow from operating activities for firm i at time t. CFI = cash flow from investing activities for firm i at time t. CFF = cash flow from financing activities for firm i at time t.

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APPENDIX A Relative Information Content Tests in Each Life-cycle Stage

1.

NI =R CFO Run regressions with Whites adjustment: MVEit = 0+ 1BVEit + 2NIit + 3CFOit + _ 1it (4a)

a.

Information content of NI:

Define X as a (n x 3) matrix with a column of 1s to the left of columns BVE and NI. Define Y as a (n x 2) matrix with columns BVE and CFO. Define M as a (2 x 2) matrix = YY - YX(XX)-1XY, with elements mij. Set N = b. m11*d3^2 +m22*d4^2 + 2* m12*d3* d4

Information content of CFO:

Define X as a (n x 3) matrix with a column of 1s to the left of columns for BVE and CFO. Define Y as a (n x 2) matrix with columns BVE and NI. Define M as a (2 x 2) matrix = YY - YX(XX)-1XY, with elements mij. Set CFO = c. m11*d1^2 + m22*d2^2 + 2*m12*d1*d2 N = R CFO.

Use Wald Test to test the following restrictions:

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APPENDIX A (continued) 2. NI =R CFI Run regressions with Whites adjustment: MVEit = 0+ 1BVEit + 2NIit + 3CFIit + _ 2it a. Information content of NI: (4b)

Define X as a (n x 3) matrix with a column of 1s to the left of columns BVE and NI. Define Y as a (n x 2) matrix with columns BVE and CFI. Define M as a (2 x 2) matrix = YY - YX(XX)-1XY, with elements mij. Set N = b. m11*l3^2 + m22*l4^2 + 2* m12*l3*l4

Information content of CFI:

Define X as a (n x 3) matrix with a column of 1s to the left of columns for BVE and CFI. Define Y as a (n x 2) matrix with columns BVE and NI. Define M as a (2 x 2) matrix = YY - YX(XX)-1XY, with elements mij. Set CFI = c. m11*l1^2 + m22*l2^2 + 2*m12*l1*l2 N = R CFI.

Use Wald Test to test the following restrictions:

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APPENDIX A (continued) 3. NI =R CFF Run regressions with Whites adjustment: MVEit = 0+ 1BVEit + 2NIit + 3CFFit + _ 3it a. Information content of NI: (4c)

Define X as a (n x 3) matrix with a column of 1s to the left of columns BVE and NI. Define Y as a (n x 2) matrix with columns BVE and CFF. Define M as a (2 x 2) matrix = YY - YX(XX)-1XY, with elements mij. Set N = b. m11*n3^2 +m22*n4^2 + 2* m12*n3* n4

Information content of CFF:

Define X as a (n x 3) matrix with a column of 1s to the left of columns for BVE and CFF. Define Y as a (n x 2) matrix with columns BVE and NI. Define M as a (2 x 2) matrix = YY - YX(XX)-1XY, with elements mij. Set CFF = m11*n1^2 + m22*n2^2 + 2*m12*n1*n2 c. Use Wald Test to test the following restrictions: N = R CFF.

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Other examples in the business press include: Cash is king, Small Business Reports 1991, pp. 48-56; Cash is king for corporate Japan, Business Week 1995, p. 37; Where cash flow is king, The Economist 1995, p. 80. 2 Incremental value-relevance is concerned with the overlap of the circles. For example, if the information from earnings is in circle A, and the information from one of the cash flow measures is in circle B, circles A and B can overlap to some extent and both may be incremental to the other unless the circles are coincidental. But, tests of incremental informativeness or valuerelevance do not test for which circle is larger the other. For a more extensive discussion on relative vs. incremental information content see Biddle, Seow, and Siegel (1995). 3 Despite the fact that the great majority of firms on Compustat and CRSP are in later life-cycle stages, a sample of 192 firm-years is obtained for the start-up group. Mikkelson and Shah (1993) in a study of IPO firms, found a substantial number of firms (52) during the 1980 - 83 time period, which had gone public, had data available on Compustat, and had no more than one year of sales history. They provided me with a listing of these firms. I have also been able to use an IPO database provided by Jay Ritter to get some of the stock return data for these firms. Data from these sources are supplemented with data obtained from Compustat, CRSP, Moodys Industrial manual, and annual reports to complete the data requirements for firms, which meet the criteria for start-ups. This group consists of over a hundred firms that have data on Compustat or in annual reports.

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