Middlesex University Research Repository An open access repository of Middlesex University research http://eprints.mdx.ac.uk Stephanou, Melita (2005) The usefulness of earnings and cash flows in valuing security returns: empirical evidence for the U.K, U.S.A and France. PhD thesis, Middlesex University. [Thesis] This version is available at: https://eprints.mdx.ac.uk/6567/ Copyright: Middlesex University Research Repository makes the University’s research available electronically. Copyright and moral rights to this work are retained by the author and/or other copyright owners unless otherwise stated. The work is supplied on the understanding that any use for commercial gain is strictly forbidden. A copy may be downloaded for personal, non-commercial, research or study without prior permission and without charge. 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See also repository copyright: re-use policy: http://eprints.mdx.ac.uk/policies.html#copy MX 7317897 7 oarH Library The Usefulness of Earnings and Cash flows in Valuing Security Returns: Empirical Evidence for the U.K, U.S.A and France by Melita Stephanou Degree Awarded by Middlesex University School of Business Ph.D Dissertation Submitted in partial fulfilment of the Ph.d requirements November, 2005 The Usefulness of Earnings and Cash flows in Valuing Security Returns: Empirical Evidence for the U.K, U.S.A and France by Melita Stephanou Degree Awarded by Middlesex University School of Business Ph.D Dissertation Submitted in partial fulfilment of the Ph.d requirements Dissertation Committee Members: Dr. Ephraim Clark, Middlesex University (Supervisor) Dr. David North, Middlesex University (Chair) Dr. Philip Arestis, Cambridge University (External Examiner) Dr. Bernard Grand, University de Marseille-Aix en Provence (External Examiner) November, 2005 The Usefulness of Earnings and Cash flows in Valuing Security Returns: Empirical Evidence for the UK, the USA and France ABSTRACT In this dissertation, I proposed to examine and test empirically six major hypotheses that relate to the role of financial information, namely earnings and cash flows, in three major capital markets, two Anglo-Saxon, the UK and the USA and one code law country, France. A theoretical framework is developed to set the groundwork for building up my research hypotheses. I hypothesize that the homogeneity across firms may not hold, due to firm-specific, industry-specific, and country specific differences across firms. The dataset consists of36,695 USA, 4,234 UK and 1,181 French firm-year observations over the period 1990-98. Multivariate statistical regression analysis is undertaken to test the major research hypotheses. The major conclusions drawn from the empirical results are summarized as follows. First, results indicate that indeed both earnings and cash flows are taken into consideration by investors in their investment decisions. Second, given cash flows, results show that earnings are always very important to investors and financial analysts for investment purposes; given earnings though results show that cash flows are more important to investors in the Anglo-Saxon countries, possibly due to the lower importance that investors place on the manipulated earnings in these less conservative countries. As far as France is concerned, results reveal that investors place much more attention to earnings and less attention to cash flows. Third, results show that the value relevance of earnings and cash flows is industry specific. Fourth, evidence shows that investors pay more attention to longer-run earnings and cash flows rather than to shorter-run financial information. Fifth, when earnings are transitory (not stable), investors pay more attention to cash flows and less attention to earnings, a result indicating that investors penalize firms with unstable earnings. Sixth, results show that the value relevance of earnings and cash flows is country specific. Specifically, results indicate that earnings are valued more in France and less in the Anglo-Saxon countries, due to the fact that the financial reporting in the Anglo- Saxon countries is much more liberal (less conservative) and managers may manipulate easier financial information. Moreover, as hypothesized, results show that cash flows are the most (least) value relevant in the USA and the UK (France). In summary, the evidence provided in this dissertation supports that indeed there are substantial differences in the way investors and financial analysts perceive financial information such as earnings and cash flows in the UK, France and the USA. The results of this dissertation should be of great importance to the major stakeholders such as investors, creditors, financial analysts, especially after the latest financial scandals and collapses of giant organizations worldwide. Furthermore, these results support that fundamental analysis does play a very important role in the capital markets and it should be taken more seriously into consideration by the stakeholders for investing, credit, financing and valuation analysis purposes. The Usefulness of Earnings and Cash flows in Valuing Security Returns: Empirical Evidence for the UK, the USA and France Table of Contents Pase # CHAPTERI. Introduction 1 CHAPTER II. Criticai Review of the Value Relevance Literature 10 2.1 Introduction 10 2.2 The value relevance of earnings and cash flows 11 2.3 The role of earnings in the capital markets 13 2.4 The role of the cash flows in the capital markets 22 2.5 The use of contextual factors in improving the association between financial information and security returns 31 2.5.1 The effect of the measurement interval 3 8 2.5.2 The effect of earnings persistence 39 2.5.3 The effect of fìrm's growth 40 2.5.4 The effect offirm's size 41 2.5.5 The effect of operating cycle length 43 2.5.6 The effect of aggregate accruals 43 2.6 Summary of the criticai review of the value relevance literature 44 CHAPTER III. Criticai Review of the International Financial Re portin g Literature 47 3.1 Introduction 47 3.2 International classification of financial reporting Systems 48 3.3 Financial reporting in France, U.K and USA 53 3.3.1 Financial reporting in France 53 3.3.2 Financial reporting in the UIC 56 3.3.3 Financial reporting in the USA 57 3.4 Comparative analysis of the financial reporting Systems in the UK, USA and France 59 3.5 Différences in the value relevance of earnings and cash flows between Anglo-Saxon countries (US and UK) and France 71 3.6 Financial reporting in the UK: The Statement of Cash flows (FRS#1) 72 3.7 Comparative analysis of the empirical évidence on the value relevance of earnings and cash flows in the UK, USA and France 75 i 3.7.1 Empirical evidence on the value relevance of earnings and cash flows in the USA 76 3.7.1.1 When long return intervals are considered 77 3.7.1.2 When transitoriness of earnings is considered 79 3.7.1.3 Level of operating cycle and industry effects 80 3.7.2 Empirical evidence on the value relevance of earnings and cash flows in the UK 81 3.7.3 Empirical evidence on the value relevance of earnings and cash flows in France 83 3.7.4 Comparative analysis 85 3.8 Summary of the critical literature review 88 CHAPTER IV: Theoretical Framework, Motivation for the Study and the Research Hypotheses 90 4.1 Theoretical Framework on the value relevance of earnings and cash flows 90 4.1.1 Theoretical framework and modeling of contextual factors 102 4.1.1.1 Permanent vs transitory earnings 102 4.1.1.2 Framework on the earnings transitoriness 104 4.1.1.3 Theoretical framework for long return intervals 106 4.1.2 Summary on the theoretical framework 110 4.2 Research hypotheses 111 4.2.1 Hypothesis 1 : There exists a positive association between operating earnings (cash flows) and returns in the UK, USA and France 111 4.2.2 Hypothesis 2: Operating earnings (cash flows) are associated with returns, given cash flows (earnings) in the UK, USA and France 112 4.2.3 Hypothesis 3. The relative informativeness of operating earnings and cash flows is industry specific in the U.K, USA and France 114 4.2.4 Hypothesis 4: The value relevance of earnings and cash flows improves as the measurement interval increases. 115 4.2.5 Hypothesis 5: The value relevance of cash flows improves when earnings are transitory 116 4.2.6 Hypothesis 6: The relative informativeness of earnings and cash flows is country specific. 118 4.2.7 Summary of the research hypotheses 119 4.3 Notation of all variables included in the equations 121 CHAPTER V State of the Art Methodologies and Techniques Employed 123 5.1 Sources of data 123 5.2 Measurement of financial and market