The article “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?” by Richard G. Sloan presents a study of the factors which affect the stock prices based on the financial statement of the company. The paper analyzes a considerable body of historical data to formulate a cohesive conclusion.
The author performed the analysis to test the two hypotheses. The first one states that “The persistence of current earnings performance is decreasing in the magnitude of the accrual component of earnings and increasing in the magnitude of the cash flow component of earnings” (Sloan 291). Essentially, it means that the companies with high cash flow earnings are more capable of maintaining their performance compared to the companies with high accrual component. The second thesis states “The earnings expectations embedded in stock prices fail to reflect fully the higher earnings persistence attributable to the cash flow component of earnings and the lower earnings persistence attributable to the accrual component of earnings” (Sloan 292). The author also proposes the investment strategy based on this fact and predicts that abnormal earnings achievable through the exploitation of it will be clustered around future earnings announcements.
The hypotheses are tested through the empirical data analysis. The sample was formed using the 1993 versions of the Compustat annual industrial and research data and CRSP monthly stock return information. The data prior to 1962 was discarded since it was shown to be biased by the previous research. Since the tests required stock return data, no information from the years after 1991 was used as well. The final sample consisted of the 40,679 observations which contained all of the necessary data. The analysis utilized the variables of earnings, accruals, and cash from operations. All of these values were adjusted based on the size of the company and possible deviations. The information was used to calculate the persistence coefficients, using the regression method, in order to test the first hypothesis. The second part of the analysis employed the framework created by Mishkin to verify whether the market takes all of the available data into account when determining stock prices. The claim that abnormal earnings are clustered around earnings announcements is also supported by the comprehensive set of data found during the analysis.
The author proves that the first hypothesis is true and provides data which supports his claim that the market does not adequately account for the different impact that accruals and cash flow have on the persistence of the current earnings. He states that these findings are not in line with the traditional efficient market view. However, the author clarifies that it does not necessarily mean that the investors are irrational or that unexploited opportunities exist in the market. The strategy he described is likely not used due to the high information acquisition costs and operational difficulties. Sloan notes that the results call for the future investigation. For instance, studying the link between the earnings components and the persistence of earnings can uncover some unexpected data.
The article presents a comprehensive overview of the issue which apparently compromises the traditional views of the efficient market. The author provides an in-depth study based on a large sample of accurate data and draws conclusions which can be used in future research. The author also covers various implications and possible implementations of his findings. Overall, the article presents a valuable piece of research which can be useful even today despite its age.
Sloan, Richard G. “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?” The Accounting Review 71.3 (1996): 289-315. Print.