Earnings, cashflows and returns: Functional relations and the impact of firm size

Abstract

The relation between stock returns, earnings and cashflows is of importance because it directly addresses the issue of whether accounting data provide value relevant information. The empirical evidence to date, however, has documented low explanatory power for earnings and inconclusive incremental information content for cashflows. This research re‐evaluates the incremental information content debate using Australian data. Our research is motivated by: recent innovations in research design, including the specification of nonlinear functional relations between accounting variables and prices, and the fact that differences in firm size characteristics may influence the relative information content of the accounting variables. We observe that: (i) a nonlinear functional relation provides greater explanatory power for both earnings and cashflows;(ii) the results are consistent with more transitory earnings components for smaller firms; and (iii) contrary to received theory, cashflows add greater incremental explanatory power for large firms.