Cash‐flows, earnings, and time‐varying expected stock returns

Abstract

Purpose

The objective of this paper is to empirically evaluate alternative multifactor explanations of cash‐flows and earnings momentum portfolios. It aims to examine whether the common risk factors, which are related to firm level accounting characteristics, can reflect the behavior of average portfolio returns based on such measures as cash‐flows and earnings momentum in the presence of each other's systematic components and time‐varying measures of volatility.

Design/methodology/approach

The paper uses monthly stock returns for all NYSE firms on CRSP database and constructs average portfolio returns between July 1951 and June 2008. It investigates the interdependence of stock returns for cash‐flows and earnings momentum portfolios using their systematic components. The methodology is implemented by extending various characteristic‐based factor models of returns.

Findings

The main finding of the study suggests that there is strong information transmission – both in the temporal variation and risk sensitivities of the average returns of cash‐flows and earnings momentum portfolios. Also, there is compelling empirical evidence that the associated systematic components well complement the ability of common risk factors to explain the temporal behavior of all NYSE stocks.

Research limitations/implications

While the results are statistically significant, the effect of aggregate risk in factor model is dubious. An integration of other accruals based accounting characteristics would be an interesting issue to explore.

Practical implications

The goal of the paper is to examine how different combinations of empirically determined variables that are instrumental in the creation of style‐specific benchmarks can capture the time‐series variation of average portfolio returns. It will provide added value to scholars and investment professionals in making effective portfolio management decisions.

Originality/value

Compared to the existing literature, in the evaluation of earnings and cash‐flows based measures, the paper focuses on the predictive power of the systematic components. It shows that paying close attention to the systematic components clearly provides additional information about the time‐varying behavior of average stock returns. The findings that the economic characteristics of the firm can complement the comparative role of the systematic components of cash‐flows and earnings add significantly to the literature.

Citation

Eugene Simlai, P. (2013), "Cash‐flows, earnings, and time‐varying expected stock returns", Journal of Economic and Administrative Sciences, Vol. 29 No. 1, pp. 42-62. https://doi.org/10.1108/10264111311319222