The determinants and valuation effects of classification choice on the statement of cash flows

In this paper we exploit the choice allowed by International Financial Reporting Standards (IFRS) regarding the presentation of interest payments on the cash flow statement to answer two related questions: First, whether the classification choice is explained by firm reporting incentives and second, whether it is value relevant. Using a UK sample, we find that firms reporting losses, with a greater proportion of their debt stemming from public sources, with CFO-based covenants and greater increases in leverage in the year of adoption are less likely to report interest payments in cash flows from operating activities (CFOA). Results also suggest that the incentive to meet or beat analyst CFO forecasts decreases, but strong corporate governance increases the probability of including interest payments in CFOA. Based on the assumption that the decision not to classify interest payments in CFOA captures lower disclosure quality or poor future expected performance, we posit that these firms should also exhibit lower valuations. Results obtained after correcting for self-selection bias confirm this assertion. We conclude that managers’ decision not to classify interest payments in CFOA is consistent with the opportunistic use of the choice allowed by IFRS.     

Equity valuation: A survey of professional practice

This paper reports the results of a scientific survey of the equity valuation practices of CFA Institute members with equity analysis job responsibilities. Using an instrument designed to minimize biases in prior valuation surveys and sampling a larger group than in previous studies (13,500 investment professionals, resulting in 1,980 valid completed questionnaires), this paper documents professional practices in the selection of equity valuation approaches, including specific model variations and key input preferences. Important differences in practice were observed across geographies and employer firm types.     

From dividend yield to discounted cash flow: a history of UK and US equity valuation techniques

This article explores how, as capital markets developed, equity valuation methods changed. The history of equity valuation is described, from its early origins during the South Sea Bubble, through the new issue boom of the nineteenth century and the stock market booms of the 1920s and 1950s. The moves from dividend yield and asset backing, to earnings yield and then P/E ratios are chronicled. The article compares developments in the UK and the US, in particular the relative slowness of the UK market to adopt US-pioneered techniques such as the P/E ratio, the concept of value versus growth stocks, and using intrinsic value to determine whether shares are cheap or dear. The article concludes with a discussion of the relatively slow introduction of the dividend discount model and of discounted cash flow as equity valuation tools on both sides of the Atlantic.     

Unusual operating cash flows and stock returns

The current financial reporting of cash flows from operations does not present individual sources of these cash flows, making it difficult for investors to assess a firm’s future performance. I hand-collect individual cash flows from unusual operations and examine their characteristics for predicting future cash flows. The results show that the unusual individual cash flow items contain a significant incremental predictive ability for future cash flows. Additional return tests show that stock prices fail to fully reflect their predictive value, suggesting that the current reporting practice may mislead investor perceptions of a firm’s cash generating ability and investors could benefit from a more explicit presentation of cash flows from operations.     

Investment opportunities,free cash flow,and stock valuation effects of secured debt offerings

This paper examines the role of investment opportunities and free cash flow in explaining the source of the stock valuation effects of secured debt offerings. We find a significantly positive relation between a firm's investment opportunities and its stock price response to announcements of secured debt issues. This evidence supports the investment opportunities hypothesis that secured debt financing is more valuable for issuing firms with high growth opportunities. In contrast, we find a lack of support for the free cash flow hypothesis. These findings hold even after controlling for other potentially influential variables. Our study provides a better understanding of the relative importance of various potential determinants in explaining the variation in the valuation impact of secured debt issues.

The role of disaggregation of earnings in stock valuation and earnings forecasting

This paper compares and contrasts two accounting information systems, the aggregate earnings system and the disaggregated cash flow/accrual system, examining their relative performance in stock valuation and in forecasting of earnings. It finds, in general, that the forecasts of earnings and predicted market values from the cash flow and accrual system have smaller forecasting errors than those from the aggregate earnings system. The adjusted R-squareds from the disaggregated system are in the main higher than those from the aggregated system when considering the explanatory power of the model-predicted values. The results also show that the cash flow and accrual system forecasts dominate the aggregate earnings system forecasts in a large majority of industries.     

Earnings quality,bankruptcy risk and future cash flows

Prior research suggests that the quality of accruals may be compromised where the magnitude of accruals is abnormally high, due to the presence of errors in the accruals‐estimation process (Dechow and Dichev, 2002; Richardson, 2003). A consequence of this is that abnormal accruals may not map into realised future cash flows to the extent that would normally be expected of accruals data. Indeed, the association may be insignificant if abnormal accruals consist primarily of estimation noise. Our study investigates whether abnormal accruals for UK firms provide incremental insight into future cash flows. In particular, our paper may be viewed as a development of Subramanyam (1996). We find a significant positive association between abnormal accruals and one‐year‐ahead operating cash flows. This provides a rationale for the pricing of abnormal accruals by the market (Subramanyam, 1996; Xie, 2001) and suggests that abnormal accruals are not merely the products of noise in the accruals‐estimation process. However, our results are conditional upon the probability of one‐year‐ahead bankruptcy risk (Charitou et al., 2004). We also find that abnormal accruals possess small but significant explanatory power for future cash flows even when controlling for the disaggregation of accruals into individual items (Barth et al., 2001).     

Rational Pricing of Internet Companies Revisited

In this article we expand and improve the Internet company valuation model of Schwartz and Moon (2000) in numerous ways. By using techniques from real options theory and modern capital budgeting, the earlier paper demonstrated that uncertainty about key variables plays a major role in the valuation of high growth Internet companies. Presently, we make the model more realistic by providing for stochastic costs and future financing, and also by including capital expenditures and depreciation in the analysis. Perhaps more importantly, we offer insights into the practical implementation the model. An important challenge to implementing the original model was estimating the various parameters of the model. Here, we improve the procedure by setting the speed of adjustment parameters equal to one another, by tying the implied half‐life of the revenue growth process to analyst forecasts, and by inferring the risk‐adjustment parameter from the observed beta of the company's stock price. We illustrate these extensions in a valuation of the company eBay.     

Opciones reales: una propuesta para valorar proyectos de I+D en centros públicos de investigación agraria

Investment decisions in research and development (R&D) are important to the success of organizations, especially for public research. This paper evaluates an R&D project (seed breeding) using the traditional method, the Net Present Value, and the more contemporaneous technique of real options. Economic Surplus Theory and Monte Carlo simulations are used to estimate social benefits. The results indicate that the real-options approach is a useful tool for assessing R&D public projects.     

High-speed rail transport valuation

In this paper, the optimal timing for investing in high-speed rail projects under uncertainty in relation to the utility provided to railway users was investigated. To accomplish this, a continuous time real options analysis framework using a stochastic demand model was developed to determine the optimal time to invest. Uncertainty upon investment expenditures was also added in an extended framework. The value of the option to defer and the investment opportunity value were also assessed.     

Managerial discretion to delay the recognition of goodwill impairment: The role of enforcement

Under International Financial Reporting Standards, managers can use two approaches to increase the estimated fair value of goodwill in order to justify not recognizing impairment: (1) make overly optimistic valuation assumptions, and (2) increase future cash flow forecasts by inflating current cash flows. Because enforcement constrains the use of optimistic valuation assumptions, we hypothesize that enforcement influences the relative use of these two choices. We test this hypothesis by comparing a sample of 1,958 firms from 36 countries that are likely to delay recognizing goodwill impairment (suspect firms) to a sample of control firms. First, we find that firms in high‐enforcement countries use a higher discount rate to test goodwill for impairment than firms in low‐enforcement countries. We also find a more positive association between discount rate and upward cash flow management for suspect firms than for control firms. This result is consistent with suspect firms substituting optimistic valuation assumptions with inflated current cash flows. Second, we find that, relative to control firms, suspect firms exhibit higher upward cash flow management in high‐enforcement countries than in low‐enforcement countries. Third, we show that suspect firms in high‐enforcement countries are more likely to eventually impair goodwill.     

High-speed rail transport valuation and conjecture shocks

In this paper, we derive the optimal investment policy in a high-speed rail transport (HSR) project. We assume that the source of uncertainty comes from the annual demand, and that it follows a geometric Brownian motion with jumps of random magnitude, occurring in random times, according to a Poisson process. We assess the impact of these shocks on the demand threshold, along with the investment opportunity value and option to differ. We consider several distributions for these jumps, and we compare with the no-jumps case. Numerical results are presented, showing the importance of assumptions about the underlying stochastic process.     

Consistent valuation of project finance and LBOs using the flows‐to‐equity method

The flows‐to‐equity method is used to value transactions where debt amortizes according to a fixed schedule, requiring a formula that links the changing leverage with a time‐varying equity discount rate. We show that extant formulas yield incorrect valuations because they are inconsistent with the basic assumptions of this method. The error from using the wrong formula can be large, especially at currently low interest rates. We derive a formula that captures the effects of a fixed debt plan, potentially expensive debt, and costs of financial distress. We resolve an important issue about what to use as the cost of debt.     

Operating cash flow asymmetric timeliness in Australia

Operating cash flow (CFO) asymmetric timeliness occurs when CFO reflects bad news more quickly than good news. We examine the presence and determinants of CFO asymmetric timeliness in Australia, where substantial differences in reporting requirements of cash flow components, in characteristics of listed companies and in the degree of conservative financial reporting produce contrasting findings to those in the United States. We find supportive evidence for the novel ‘sticky cost behaviour’ explanation and also the product-pricing strategy, but not the life cycle hypothesis. These findings are useful for investors and analysts concerned with forecasting the future values of companies.     

Auditor quality effects on the relationship between accruals,cash flows and equity returns: a variance decomposition analysis

In this paper, we examine the relative importance of the cash flow and accruals components of earnings in explaining the variation in UK company equity returns, together with the extent to which these relationships vary by auditor quality. We use a multivariate time-series approach that can be reconciled to a log-linear theoretical valuation model and, unlike the standard linear regression of returns on earnings components, accommodates time-varying discount rates. Based on a decomposition of the variance of equity returns, cash flows and accruals, our results indicate that both cash flow news and accruals news are important drivers of UK equity returns, although cash flows are more influential than accruals. We also find that variation in both earnings components has a more significant effect on returns for clients of large auditors. Finally, our results provide mixed evidence on the question of whether the impact of auditor quality is highest for the accruals component of earnings.