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.
1
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 X
2
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.
2
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
3
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 value-
relevance 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 life-
cycle 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
4
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 life-
cycle 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),
5
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 value-
relevance 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-
6
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):
7
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:
MVE
it
= a
1
BVE
it
+ a
2
UNA
it
(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 a
2
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 a
1
and a
2
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
8
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:
MVE
it
= a
0
+ a
2
BVE
it
+ a
2
UNA
it
+ e
it
. (3)
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
9
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 value-
relevant 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 long-
term 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 value-
relevant than earnings.
10
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
11
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
12
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 life-
cycle 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 firm-
year observations:
192 Start-up observations
7,162 Growth observations
13
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.
14
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 life-
cycles 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.
15
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 firm-
years 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;
16
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.
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFO
it
+ _ 1
it
(4a)
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFI
it
+ _ 2
it
(4b)
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFF
it
+ _ 3
it
(4c)
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.
17
Null hypotheses for the relative value-relevance hypotheses become:
Null Hypotheses SUBSET 1 SUBSET 2 EQUATION
NI =
R
CFO NI CFO 4a
NI =
R
CFI NI CFF 4b
NI =
R
CFF NI CFI 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, X
1
and X
2
, the matrix Y
1
consists of the columns of X that are not in X
1
, and similarly for Y
2
. B
1
and B
2
are subsets (1
and 2, above) of regression coefficients for Y
1
and Y
2,
, respectively. Thus, the null hypothesis
becomes in general form: (equation 3.1 from Siegel & Biddle 1994)
H
O
: B
1
Y
1
[I
n
- X
1
(X
1
X
1
)
-1
X
1
]Y
1
B
1
= B
2
Y
2
[I
n
- X
2
(X
2
X
2
)
-1
X
2
]Y
2
B
2
(5)
This nonlinear hypothesis is of quadratic form in the regression coefficients. The left-
hand side of the hypothesis represents the bias due to omitting Y
1
from the regression, keeping
only X
1
, which is a quadratic form in the omitted regression coefficients B
1
. The right-hand side
represents the bias when Y
2
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 value-
relevant 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 value-
relevant 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 X
2
statistic is significant. The Wald
X
2
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 R
2
statistic is needed for regressions of equation 3, substituting the different
independent variables for UNA. Table 5, Panel B, R
2
statistics from regressions of equation 3
provide evidence that CFI (R
2
=0.33) is more value-relevant than earnings (R
2
=0.12). Neither
operating nor financing cash flows is significantly more value-relevant than earnings, although
the R
2
statistics are higher for these variables than for earnings.
In the growth stage, the hypotheses predict that the cash flow measures are more value-
relevant 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
X
2
statistic is significant. The R
2
statistics in Table 6, Panel B provide evidence that CFO (R
2
=
19
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 X
2
statistics are significant in each of the
regressions. The R
2
statistics in Table 7, Panel B provide evidence that NI (R
2
=0.80) is more
value-relevant than CFO (R
2
=0.75), CFI (R
2
=0.75), or CFF (R
2
=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 X
2
statistics are significant in each of
the regressions. The R
2
statistics in Table 8, Panel B provide evidence that NI (R
2
=0.87) is
more value-relevant than CFO (R
2
=0.82), CFI (R
2
=0.81), or CFF (R
2
=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
20
flow measures are incrementally significant, but financing cash flows are not significant. Wald
X
2
statistics are significant only in equation 4a. The R
2
statistics in Table 9, Panel B provide
evidence that CFO (R
2
=0.80) is more value-relevant than NI (R
2
=0.76). For CFI (R
2
=0.78)
and CFF (R
2
=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 value-
relevant 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 X
2
statistics are significant only in equation 4a. The R
2
statistics
in Table 10, Panel B provide evidence that CFO (R
2
=0.48) is more value-relevant than NI (R
2
=
0.39). For CFI (R
2
=0.38) and CFF (R
2
=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 R
2
statistics of the
regressions in these stages was on the order of 0.80, while in the start-up and decline stages the
R
2
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 life-
cycle 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
21
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.
22
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
23
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 R
2
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.
24
ENDNOTES
1
Other examples in the business press include: Cash is king, Small Business Reports 1991, pp.
48-56; Cash is king for corporate J apan, 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 value-
relevance 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 J ay 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.
25
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28
Table 1
Descriptive Statistics by Life-Cycle Stage (Medians)
# Observations 192 7,162 7,350 6,169 8,514 8,574
Variable Start-up Growth Growth/
Mature
Mature Mature/
Decline
Decline
Market Value of
Equity
16.52 21.95 164.19 208.47 24.64 10.91
Book Value of
Equity
3.40 12.16 115.13 128.84 13.73 4.41
Net Income -0.29 0.66 14.76 16.15 0.16 -0.52
Cash Flow from
Operations
-0.60 0.89 20.18 22.06 0.91 -0.02
Cash Flow from
Investing
-0.83 -3.88 -21.90 -19.37 -1.19 -0.163
Cash Flow from
Financing
1.93 1.86 -0.31 -1.57 0 0
Sales Growth (%) 27.21 38.32 12.30 8.29 6.16 -13.24
Capital
Expenditure Ratio
0.09 0.13 0.10 0.07 0.04 0.02
Capital
Expenditures
0.29 4.21 21.80 3.95 1.14 0.22
Dividend Payout
Ratio
0 0 0.33 0.36 0 0
Size
(Total Assets)
5.05 29.97 269.59 282.62 33.86 12.52
Debt to Equity
Ratio
0.06 0.42 0.57 0.49 0.30 0.16
Firm Age 2.36 16.48 24.43 33.51 38.64 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).
29
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) / SALESt-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.
30
Table 2
Industry Composition by Life-Cycle Stage
Industry Start-
up
Growth G/M Mature M/D Decline Total
00-09 Agriculture &
Const. Matl
0 41 30 36 56 61 224
10-14 Mining, Oil &
Gas
2 1452* 303 310 748* 216 3031
15-19 Construction 0 94 117 108 159* 108 586
20-22 Consumer
Goods & Food
0 238 689* 476* 211 585* 2199
23-25 Apparel 0 149 329 298 325 417* 1518
26-27 Business Sup.,
Printing, & Publishing
4 161 581* 408* 155 301 1610
28 Pharmaceuticals &
Chemicals
15 283 469 556* 823* 336 2482
29 - Oil and Gas
Refineries & Retail
0 31 195* 163* 21 60 470
30 Rubber & Plastic 2 162 242* 159* 133 108 806
31-33 Manufactured
Prods: Steel, Const.
Matl, & Clothing
6 191 421* 376* 218 686* 1898
34 Fabricated Prods 3 167 335* 283* 215 385* 1388
35 Machinery 29* 656 644 553 1012* 935* 3829
36 Electrical Eq. 12 789* 479 432 979* 749 3440
37 Autos, Rail, Ships
& Aircraft
7 163 339* 269* 184 265 1227
38-39 Medical,
Measurg & Control Eq
21 514 489 491 1114* 580 3209
50-59 Wholesale &
Retail
37 1157 1217 875 993 2237* 6516
70-89 Restaur.,
Lodging, Computers,
Bus. & Pers. Services
52* 883* 465 374 1076* 541 3391
90-99 Other 2 31 6 2 92* 4 137
Totals by Life-Cycle
Stage 192 7162 7350 6169 8514 8574 37961
An asterisk (*) indicates a significant X
2
where observations were significantly greater than the overall
distribution.
31
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 1 220 627* 346* 149 269 1612
1978 1 243 601* 296* 152 245 1538
1979 2 272 574* 304* 175 315 1642
1980 3 229 515* 383* 205 548* 1883
1981 11 439* 529* 344 260 424 2007
1982 26* 303 384 372 398 671* 2154
1983 32* 333 415 367 396 577* 2120
1984 26* 628* 510* 296 324 353 2137
1985 27* 338 333 353 497 554* 2102
1986 19* 348 298 309 491* 447 1912
1987 15 577* 359 305 482 341 2079
1988 13 494* 353 332 446 377 2015
1989 3 384 313 296 513 671* 2180
1990 4 434 308 317 512 707* 2282
1991 2 244 191 280 674* 872* 2263
1992 4 282 206 294 726* 813* 2325
1993 3 343 245 296 753* 109 1749
1994 0 564* 330 363 681* 147 2085
1995 0 487* 259 316 680* 134 1876
Total 192 7162 7350 6169 8514 8574 37961
An asterisk (*) indicates a significant X
2
where observations were significantly greater than the overall
distribution.
32
Table 4
Regression Variable Correlations by Life-Cycle Stage
A. Start-up
MVE BVE NI CFO CFI
BVE 0.17
NI -0.05 -0.02
CFO -0.04 -0.04 0.29
CFI -0.29 -0.19 -0.03 -0.01
CFF 0.09 0.03 -0.13 -0.64 -0.38
B. Growth
MVE BVE NI CFO CFI
BVE 0.89
NI 0.60 0.69
CFO 0.77 0.77 0.60
CFI -0.61 -0.59 -0.23 0.34
CFF 0.39 0.39 0.05 -0.68 -0.88
C. Growth/Mature
MVE BVE NI CFO CFI
BVE 0.87
NI 0.88 0.90
CFO 0.83 0.93 0.92
CFI -0.79 -0.87 -0.84 -0.33
CFF -0.20 -0.24 -0.29 -0.89 0.10
D. Mature
MVE BVE NI CFO CFI
BVE 0.89
NI 0.92 0.92
CFO 0.90 0.93 0.92
CFI -0.80 -0.80 -0.79 -0.86
CFF -0.14 -0.23 -0.20 -0.23 -0.27
Bold indicates significance at the 0.05 level.
33
Table 4
Regression Variable Correlations by Life-Cycle Stage (continued)
E. Mature/Decline
MVE BVE NI CFO CFI
BVE 0.88
NI -0.11 -0.14
CFO 0.79 0.76 -0.42
CFI -0.67 -0.64 0.15 -0.78
CFF 0.12 0.13 0.19 0.04 -0.62
F. Decline
MVE BVE NI CFO CFI
BVE 0.68
NI 0.41 0.46
CFO 0.52 0.38 0.42
CFI -0.23 -0.18 -0.28 -0.48
CFF -0.02 -0.03 0.02 0.20 -0.61
Bold indicates significance at Th 0.05 level.
34
Table 5
Results of Relative Value Relevance of Earnings and Cash Flows - START-UP
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFO
it
+ _ 1
it
(4a)
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFI
it
+ _ 2
it
(4b)
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFF
it
+ _ 3
it
(4c)
Panel A: Regression Results
Equation
Regression Variable
4a (CFO)
Coefficient Estimate
4b (CFI)
Coefficient Estimate
4c (CFF)
Coefficient Estimate
Intercept -10.25* -12.46* -9.32*
BVE 0.74 0.87 0.99
NI -0.59 -0.44 -0.75
CFO -1.22
CFI -0.35*
CFF 0.36
Wald X
2
Statistic 0.003
p-value =0.95
3.69
p-value = 0.05
0.521
p-value =0.47
*Significant at the 5 percent level.
35
Table 5 (continued)
MVE
it
= a
0
+ a
2
BVE
it
+ a
2
UNA
it
+ e
it
. (3)
Panel B: R
2
Results of Regressions of Equation (3).
CFO CFI CFF
Hypothesis Test NI >
R
CFO
CFO >
R
NI
NI >
R
CFI
CFI >
R
NI
NI >
R
CFF
CFF >
R
NI
Prediction NO YES NO YES NO YES
R
2
of Equation (3) with
different variables
representing UNA
NI: R
2
= 0.12
CFO: R
2
= 0.15
NI: R
2
= 0.12
CFI: R
2
= 0.33
NI: R
2
= 0.12
CFF: R
2
= 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.
36
Table 6
Results of Relative Value Relevance of Earnings and Cash Flows - GROWTH
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFO
it
+ _ 1
it
(4a)
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFI
it
+ _ 2
it
(4b)
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFF
it
+ _ 3
it
(4c)
Panel A: Regression Results
Equation
Regression Variable
4a (CFO)
Coefficient Estimate
4b (CFI)
Coefficient Estimate
4c (CFF)
Coefficient Estimate
Intercept 26.78* 24.59* 26.56*
BVE 1.29* 1.40* 1.52*
NI -0.51 0.43 0.27
CFO 1.80*
CFI -0.49*
CFF 0.28
Wald X
2
Statistic 3.26
p-value = 0.05
0.90
p-value =0.34
0.28
p-value =0.60
*Significant at the 5 percent level.
37
Table 6 (continued)
MVE
it
= a
0
+ a
2
BVE
it
+ a
2
UNA
it
+ e
it
. (3)
Panel B: R
2
Results of Regressions of Equation (3).
CFO CFI CFF
Hypothesis Test NI >
R
CFO
CFO >
R
NI
NI >
R
CFI
CFI >
R
NI
NI >
R
CFF
CFF >
R
NI
Prediction NO YES NO YES NO YES
R
2
of Equation (3) with
different variables
representing UNA
NI: R
2
= 0.77
CFO: R
2
= 0.80
NI: R
2
= 0.77
CFI: R
2
= 0.78
NI: R
2
= 0.77
CFF: R
2
= 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.
38
Table 7
Results of Relative Value Relevance of Earnings and Cash Flows GROWTH/MATURE
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFO
it
+ _ 1
it
(4a)
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFI
it
+ _ 2
it
(4b)
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFF
it
+ _ 3
it
(4c)
Panel A: Regression Results
Equation
Regression Variable
4a (CFO)
Coefficient Estimate
4b (CFI)
Coefficient Estimate
4c (CFF)
Coefficient Estimate
Intercept 2.34 7.54 -8.15
BVE 0.81* 0.63* 0.66*
NI 7.60* 6.57* 6.91*
CFO -0.96**
CFI -0.20
CFF 0.72**
Wald X
2
Statistic 8.46
p-value = 0.01
8.44
p-value = 0.01
9.17
p-value = 0.01
*Significant at the 5 percent level.
**Significant at the 10 percent level.
39
Table 7 (continued)
MVE
it
= a
0
+ a
2
BVE
it
+ a
2
UNA
it
+ e
it
. (3)
Panel B: R
2
Results of Regressions of Equation (3).
CFO CFI CFF
Hypothesis Test NI >
R
CFO
CFO >
R
NI
NI >
R
CFI
CFI >
R
NI
NI >
R
CFF
CFF >
R
NI
Prediction YES NO YES NO YES NO
R
2
of Equation (3) with
different variables
representing UNA
NI: R
2
= 0.80
CFO: R
2
= 0.75
NI: R
2
= 0.80
CFI: R
2
= 0.75
NI: R
2
= 0.80
CFF: R
2
= 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.
40
Table 8
Results of Relative Value Relevance of Earnings and Cash Flows - MATURE
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFO
it
+ _ 1
it
(4a)
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFI
it
+ _ 2
it
(4b)
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFF
it
+ _ 3
it
(4c)
Panel A: Regression Results
Equation
Regression Variable
4a (CFO)
Coefficient Estimate
4b (CFI)
Coefficient Estimate
4c (CFF)
Coefficient Estimate
Intercept 13.30 -1.83 -16.90
BVE 0.22 0.33* 0.50*
NI 9.34* 9.92* 10.69*
CFO 1.45*
CFI -0.97*
CFF 0.83**
Wald X
2
Statistic 7.66
p-value = 0.01
11.77
p-value = 0.01
19.62
p-value = 0.01
*Significant at the 5 percent level.
**Significant at the 10 percent level.
41
Table 8 (continued)
MVE
it
= a
0
+ a
2
BVE
it
+ a
2
UNA
it
+ e
it
. (3)
Panel B: R
2
Results of Regressions of Equation (3).
CFO CFI CFF
Hypothesis Test NI >
R
CFO
CFO >
R
NI
NI >
R
CFI
CFI >
R
NI
NI >
R
CFF
CFF >
R
NI
Prediction YES NO YES NO YES NO
R
2
of Equation (3) with
different variables
representing UNA
NI: R
2
= 0.87
CFO: R
2
= 0.82
NI: R
2
= 0.87
CFI: R
2
= 0.81
NI: R
2
= 0.87
CFF: R
2
= 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.
42
Table 9
Results of Relative Value Relevance of Earnings and Cash Flows MATURE/DECLINE
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFO
it
+ _ 1
it
(4a)
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFI
it
+ _ 2
it
(4b)
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFF
it
+ _ 3
it
(4c)
Panel A: Regression Results
Equation
Regression Variable
4a (CFO)
Coefficient Estimate
4b (CFI)
Coefficient Estimate
4c (CFF)
Coefficient Estimate
Intercept 71.41* 74.16* 73.48*
BVE 1.05* 1.28* 1.47*
NI 0.75* -0.25 -0.31
CFO 2.50*
CFI -1.07*
CFF 0.09
Wald X
2
Statistic 15.55
p-value = 0.01
1.95
p-value =0.16
0.11
p-value =0.74
*Significant at the 5 percent level.
**Significant at the 10 percent level.
43
Table 9 (continued)
MVE
it
= a
0
+ a
2
BVE
it
+ a
2
UNA
it
+ e
it
. (3)
Panel B: R
2
Results of Regressions of Equation (3).
CFO CFI CFF
Hypothesis Test NI >
R
CFO
CFO >
R
NI
NI >
R
CFI
CFI >
R
NI
NI >
R
CFF
CFF >
R
NI
Prediction YES NO YES NO YES NO
R
2
of Equation (3) with
different variables
representing UNA
NI: R
2
= 0.76
CFO: R
2
= 0.80
NI: R
2
= 0.76
CFI: R
2
= 0.78
NI: R
2
= 0.76
CFF: R
2
= 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.
44
Table 10
Results of Relative Value Relevance of Earnings and Cash Flows - DECLINE
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFO
it
+ _ 1
it
(4a)
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFI
it
+ _ 2
it
(4b)
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFF
it
+ _ 3
it
(4c)
Panel A: Regression Results
Equation
Regression Variable
4a (CFO)
Coefficient Estimate
4b (CFI)
Coefficient Estimate
4c (CFF)
Coefficient Estimate
Intercept 30.07* 37.39* 38.35*
BVE 1.16* 1.31* 1.35*
NI 0.59 1.44** 1.64*
CFO 2.91*
CFI -0.67*
CFF 0.31
Wald X
2
Statistic 5.68
p-value = 0.02
0.19
p-value =0.66
0.63
p-value =0.43
*Significant at the 5 percent level.
**Significant at the 10 percent level.
45
Table 10 (continued)
MVE
it
= a
0
+ a
2
BVE
it
+ a
2
UNA
it
+ e
it
. (3)
Panel B: R
2
Results of Regressions of Equation (3).
CFO CFI CFF
Hypothesis Test NI >
R
CFO
CFO >
R
NI
NI >
R
CFI
CFI >
R
NI
NI >
R
CFF
CFF >
R
NI
Prediction NO YES NO YES NO YES
R
2
of Equation (3) with
different variables
representing UNA
NI: R
2
= 0.39
CFO: R
2
= 0.48
NI: R
2
= 0.39
CFI: R
2
= 0.38
NI: R
2
= 0.39
CFF: R
2
= 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.
46
APPENDIX A
Relative Information Content Tests in Each Life-cycle Stage
1. NI =
R
CFO
Run regressions with Whites adjustment:
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFO
it
+ _ 1
it
(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)
-1
XY, with elements m
ij
.
Set N = m
11
*d
3
^2 +m
22
*d
4
^2 + 2* m
12
*d
3
* d
4
b. 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)
-1
XY, with elements m
ij
.
Set CFO = m
11
*d
1
^2 + m
22
*d
2
^2 + 2*m
12
*d
1
*d
2
c. Use Wald Test to test the following restrictions: N =
R
CFO.
47
APPENDIX A (continued)
2. NI =
R
CFI
Run regressions with Whites adjustment:
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFI
it
+ _ 2
it
(4b)
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 CFI.
Define M as a (2 x 2) matrix =YY - YX(XX)
-1
XY, with elements m
ij
.
Set N = m
11
*l
3
^2 + m
22
*l
4
^2 + 2* m
12
*l
3
*l
4
b. 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)
-1
XY, with elements m
ij
.
Set CFI = m
11
*l
1
^2 + m
22
*l
2
^2 + 2*m
12
*l
1
*l
2
c. Use Wald Test to test the following restrictions: N =
R
CFI.
48
APPENDIX A (continued)
3. NI =
R
CFF
Run regressions with Whites adjustment:
MVE
it
=
0
+
1
BVE
it
+
2
NI
it
+
3
CFF
it
+ _ 3
it
(4c)
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 CFF.
Define M as a (2 x 2) matrix =YY - YX(XX)
-1
XY, with elements m
ij
.
Set N = m
11
*n
3
^2 +m
22
*n
4
^2 + 2* m
12
*n
3
* n
4
b. 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)
-1
XY, with elements m
ij
.
Set CFF = m
11
*n
1
^2 + m
22
*n
2
^2 + 2*m
12
*n
1
*n
2
c. Use Wald Test to test the following restrictions: N =
R
CFF.
49

1
Other examples in the business press include: Cash is king, Small Business Reports 1991, pp.
48-56; Cash is king for corporate J apan, 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 value-
relevance 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 J ay 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.