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Cash Flow Patterns as a Proxy for

Firm Life Cycle

Victoria Dickinson, PhD, CPA
E. H. Patterson School of Accountancy
University of Mississippi

Current Draft: November 2010

Victoria Dickinson, University of Mississippi E.H. Patterson School of Accountancy, Conner 204C,
University, MS 38677; Phone: (662) 915-5448; Fax: (662) 915-7483; email:

This paper is based on my dissertation at the University of Wisconsin Madison. I would like to thank the members of
my committee: Don Hausch, Jed Frees, Holly Skaife, Terry Warfield, and John Wild (Chair), along with Mike Donohoe,
Frank Heflin, Ryan LaFond, Matt Magilke, Bill Mayew, Brian Mayhew, Per Olsson, K. Ramesh, Greg Sommers, Jenny
Tucker and Rodrigo Verdi for their helpful discussions and comments. This paper has also benefited from the
comments of conference participants at the American Accounting Association and from workshop participants at the
College of William and Mary, Florida State University, Miami University, University of Alabama at Birmingham,
University of Florida, University of Mississippi, University of Utah, and University of Wisconsin - Madison.
Cash Flow Patterns as a Proxy for
Firm Life Cycle

Abstract: This paper examines the validity of cash flow patterns as a proxy for firm life cycle. Cash
flow patterns provide a parsimonious, but robust, indicator of firm life cycle stage that is free from
distributional assumptions inherent when using a univariate or composite measure. Life cycle stage
is an important determinant of the level and time series properties of profitability. Return on net
operating assets (RNOA) does not mean-revert (spread of seven percent after five years) when
sorted by life cycle stage which has implications for forecasting growth rates and for determining
forecast horizons. Determinants of future profitability identified in prior literature such as asset
turnover and profit margin are differentially affected by life cycle stage. Furthermore, market
participants undervalue mature firms, specifically those with extreme book-to-market ratios. The
cash flow pattern proxy has numerous applications in forecasting and analysis and is a useful control
variable for future research.

1. Introduction
Business firms are evolving entities and the path of evolution is determined by internal
factors (e.g., strategy choice, financial resources, and managerial ability) and external factors (e.g.,
competitive environment, macroeconomic factors). Firm life cycles are distinct phases that result
from changes in these factors, many of which arise from strategic activities undertaken by the firm.
Lev and Zarowin (1999) document that: (1) the rate of business change has increased over time, and
(2) the value-relevance of earnings has decreased over time. Taken together, these findings suggest
that a non-earnings-based measure that captures firm life cycle stage would be useful to investors
and creditors. In response, this paper develops and validates a parsimonious proxy for firm life
cycle based on a firms cash flows patterns.
Capturing life cycle at the firm level (rather than at the individual product or industry level)

is a difficult undertaking. The firm is an aggregation of multiple products, each with a distinct
product life cycle stage. Additionally, the firm may compete in multiple industries such that its
product offerings are quite diverse. As a result, firm-level life cycle stage is difficult to assess
because it is a composite of many overlapping, but distinct product life cycle stages.
The economics literature has addressed individual attributes of life cycle theory such as
production behavior (Spence 1977, 1979, 1981; Wernerfelt 1985; Jovanovic and MacDonald 1994),
learning/experience (Spence 1981), investment (Spence 1977, 1979; Jovanovic 1982; and Wernerfelt
1985), entry/exit patterns (Caves 1998), and market share (Wernerfelt 1985). I propose a life cycle
proxy based on accounting information (specifically cash flow patterns) that can be linked to these
constructs from the extant economics literature.

The following studies examine the validity of product life cycle for the following industries: German automobile
manufacturers (Brockhoff 1967); pharmaceuticals (Cox 1967); tobacco, food, and personal care products (Polli and
Cook 1969); household cleansers (Parsons 1975).
Anthony and Ramesh (1992) was one of the first studies to demonstrate the usefulness of
firm life cycle in explaining market performance. However, their sample period ended before the
Statement of Cash Flows was a required disclosure. Therefore, their life cycle measure relied on a
composite of economic characteristics such as sales growth, dividend payout, capital expenditures,
and firm age. By necessity, their life cycle proxy had to rely on portfolio sorts to draw distinctions
between the life cycle stages. On the other hand, the classification scheme used in this paper is
accomplished by using a firms operating, investing, and financing cash flows in combination to
assign life cycle stage. The classification methodology is organic in that life cycle stage
identification is the result of the firms performance and allocation of resources, as opposed to
arbitrary assignment.
I use the cash flow patterns proxy to document the economic characteristics and market
behavior of firms within each life cycle stage. Specifically, I validate the cash flow proxy in relation
to competing measures for firm life cycle and find that it is better aligned with the functional form
of firm profitability. Economic theory predicts a nonlinear progression of variables such as
earnings, return on net operating assets (RNOA)
, asset turnover (ATO), profit margin (PM), sales
revenue, leverage, dividend payout, size and age across the life cycle continuum which is consistent
with the distribution that results from using cash flow patterns as a life cycle proxy.
Once the descriptive validity of the cash flow pattern proxy for life cycle is established, I
examine which life cycle stages demonstrate persistence in profitability and investigate the inter-
temporal convergence of profitability by life cycle stage. Previous research documents that
profitability measures mean-revert over time (Brooks and Buckmaster 1976; Freeman, Ohlson and

RNOA removes the effect of financing from the profitability metric and is measured as operating income divided by
net operating assets (NOA). NOA excludes financial assets from the denominator since they are already valued at fair
value on the balance sheet. NOA also subtracts out operating liabilities from operating assets. This is because operating
liabilities reflect a source of leverage that can increase profitability.
Penman 1982; Fairfield, Sweeney and Yohn 1996; Fama and French 2000; Nissim and Penman
2001) and understanding the evolution of profitability improves predictability. Conditioning an
inter-temporal analysis by life cycle stage is expected to explain differences in convergence rates
across firms. The results support that prediction. Specifically, RNOA maintains a differential
spread of three to 10 percent between decline and mature firms even after five years. This difference
is economically significant and suggests differences in firm life cycle are an impediment to the mean-
reversion of profitability.
Prior research has demonstrated that changes in future accounting returns (specifically
RNOA) are explained by level and change of current profitability, growth in net operating assets,
and by increases in the asset turnover (ATO) (Fairfield and Yohn 2001). Since firm life cycle stage
differentially explains profitability, including the cash flow pattern proxy for life cycle also provides
significant information about future change in RNOA, and the explanatory power of the cash flow
pattern proxy outperforms alternative life cycle proxies. Furthermore, the explanatory power of
changes in ATO for changes in RNOA is concentrated in the mature life cycle stage. This is
consistent with economic theory that states competitive pressures will drive mature firms to focus
on efficiency and cost containment. Also, Penman and Zhang (2006) find that increases in profit
margin (PM) result in negative future RNOA because those increases are achieved through a
reduction of operating expenses which are not sustainable. Again, this effect is concentrated in the
mature life cycle stage, where product differentiation efforts (which manifest in the PM) have
reached diminishing returns (Oster 1990, Shy 1995).
Considering that life cycle affects non-convergence of profitability over time and that life
cycle differences interact with the determinants of profitability, the next step is to investigate what
role life cycle plays in understanding current firm value and predicting stock returns. The market
does not fully capture information provided by the life cycle proxy such that mature firms earn
positive excess returns in the year following life cycle stage assignment. This indicates that investors
underestimate the persistence of the elevated profitability of mature firms and instead expect their
profitability to mean-revert to a normal level.
Prior literature has found that profitable trading strategies can be developed based on
extreme values of the book-to-market ratio (B/M) where low B/M firms are referred to as glamour
firms and high B/M firms are considered value firms (Fama and French 1992, Lakonishok et. al.
1994). Two common B/M trading strategies (Piotroski 2000, Mohanram 2005) focus on using
fundamental analyses to separate out firms that are undervalued versus those that overvalued among
the glamour/value firms. The fundamental analyses used in this line of research are comprised of
composite scores of numerous metrics (ranging from eight to nine signals for each fundamental
analysis score). The cash flow pattern proxy for life cycle provides a simple and effective way to
identify the winners among both B/M extremes using considerably less data. All market results
are robust to consideration of delisting returns and execution issues regarding shorting illiquid
In summary, this paper presents and validates cash flows patterns as a parsimonious proxy
for identifying firm life cycle stage. This classification is useful in the following contexts: (1) to
better assess growth rates and forecast horizons in valuation models; (2) to better understand how
economic fundamentals affect the level and convergence properties of future profitability; (3) to
identify firms where potential unidentified risk factors and/or market mispricing exist based on
differences in life cycle stage; (4) as a control variable for distinct economic characteristics of the
firm related to firm life cycle that affect firm performance. These contributions benefit equity
investors, creditors, auditors, analysts, regulators, and researchers alike. The remainder of the paper
is organized as follows: Section 2 presents and validates the firm life cycle proxy, Section 3
demonstrates the usefulness of the proxy in explaining future profitability, Section 4 examines the
market implications of life cycle information for future stock returns, and Section 5 concludes.

2. Is the proposed life cycle classification scheme descriptively more valid?
Gort and Klepper (1982) define five life cycle stages: (1) an introductory stage, where an
innovation is first produced; (2) a growth stage, where the number of producers increases dramatically;
(3) a maturity stage, where the number of producers reaches a maximum; (4) a shake-out stage, where
the number of producers begins to decline; and (5) a decline stage, where there is essentially zero net
entry. I propose that cash flows capture the outcome of these distinct life cycle stages. Livnat and
Zarowin (1990) document that the decomposition of cash flows into operating, investing and
financing activities differentially affects stock returns. Therefore, cash flows capture differences in a
firms profitability, growth, and risk; and the combination of those cash flows are mapped into life
cycle theory to derive the life cycle classification used throughout the paper. A survey of economic
theory related to life cycle and the predicted relation to cash flows is summarized in Table 1.
The combination of cash flow patterns represents the firms resource allocation and
operational capabilities interacted with the firms choice in strategy. Predictions about each cash
flow component can be derived from economic theory which forms the basis for the cash flow
patterns proxy for life cycle. For example, introduction firms lack established customers and suffer
from knowledge deficits about potential revenues and costs, both of which result in negative
operating cash flows (Jovanovic 1982). However, profit margins are maximized during increases in
investment and efficiency (Spence 1977, 1979, 1981; Wernerfelt 1985) which means that operating
cash flows are positive during the growth and maturity stages. Wernerfelt (1985) points out that
declining growth rates will eventually lead to declining prices such that operating cash flows will
decrease (and become negative) as firm enter the decline stage.
Managerial optimism (Jovanovic 1982) encourages firms to make early investments which
ultimately serve to deter entry into the market by competitors (Spence 1977, 1979, 1981).
Consequently, investing cash flows are negative for introduction and growth firms. While mature
firms decrease investment relative to growth firms, they will invest to maintain capital (Jovanovic
1982, Wernerfelt 1985). If the cost of maintenance increases over time (i.e., rising prices), investing
cash flows are negative for mature firms, although at a lesser magnitude than cash outflows for
introduction and growth firms. Decline firms will liquidate assets in order to service existing debt
and to support operations which results in positive cash flows from investing.
Pecking order theory states that firms initially access bank debt followed by equity later in
their life (Myers 1984, Diamond 1991). Barclay and Smith (1995) demonstrate that growth firms will
access debt that is shorter in duration than mature firms. Taken together, financing cash flows are
positive for introduction and growth firms. However, mature firms will begin to service debt and
distribute cash to shareholders as they exhaust positive net present value investment opportunities,
which results in negative financing cash flows. There is a void in the literature with respect to
whether financing cash flows will be positive or negative for decline firms.

The combination of a firms patterns of operating, investing, and financing cash inflows
and outflows provide a firm life cycle mapping at a given point in time. By using the sign (positive
or negative) of the net operating, investing and financing cash flows, eight possible cash flow pattern
combinations exist.
The eight classifications are collapsed into the five practical life cycle stages

Likewise, the literature is silent regarding cash flows for shake-out firms. As a result, shake-out firms classified by
default if the cash flow patterns do not fall into one of the other theoretically-defined stages.
Incorporating the sign and magnitude of the cash flows would likely improve performance of the proxy. However, if
positive (negative) cash flows were separated into low- and high-positive (negative) cash flows, the number of patterns
would increase to 64, which is less straightforward to connect to economic theory. For that reason, only sign is
(mentioned at the beginning of the section): introduction, growth, mature, shake-out, and decline
based on expected cash flow behaviors from Table 1.

A benefit of the cash flow pattern proxy used in this paper, is that it uses the entire financial
information set contained in operating, investing, and financing cash flows rather than a single
metric to determine firm life cycle. As mentioned in the previous section, prior literature uses sorts
on variables such as age, sales growth, capital expenditures, dividend payout or some composite of
these variables to assess life cycle stage (Anthony and Ramesh 1992, Black 1998). The drawback of
these methods, however, is that an ex ante assumption is required regarding the underlying
distribution of life cycle membership. By forming portfolios sorted on a single variable (or a
composite of those sorts), a uniform distribution of life cycle stages across firms is inherently
assumed. Cash flow patterns, on the other hand, are the organic result of a firms operations and
achieve better congruence with economic theory (i.e., a normal distribution).
Both size and firm age are common proxies for life cycle.
When size and age are used as a
life cycle proxy, an implicit assumption is that a firm moves monotonically through its life cycle.
This assumption arises because product life cycles are characterized by forward progression from
introduction to decline. However, a firm is a portfolio of multiple products, each at potentially a
different product life cycle stage. Substantial product innovations, expansion into new markets or

There are three cash flow types (operating, investing, and financing) and each can take a positive or negative sign which
results in 2
= 8 possible combinations. The 8 patterns are collapsed into five stages as follows:

Recent accounting research that relies on firm size or age to capture life cycle effects includes Bradshaw et al. (2010),
Khan and Watts (2009), Caskey and Hanlon (2007), Doyle et al. (2007), Desai et al. (2006), Freeman et al. (2006), Klein
and Marquardt (2006), Wasley and Wu (2006), Bhattacharya et al. (2004), and Chen et al. (2002). An abstract search for
firm age in SSRN yielded 592 results while a search for firm size exceeded the maximum results of 1,000 papers.
1 2 3 4 5 6 7 8
Introduction Growth Mature Shake-Out Shake-Out Shake-Out Decline Decline
Predicted sign
Cash flows from operating activities + + + +
Cash flows from investing activities + + + +
Cash flows from financing activities + + + +
structural change can cause firms to move across life cycle stages non-sequentially. For that reason,
firm life cycle can be cyclical in nature and the firms primary goal is to maintain its firm life cycle at
the growth/mature stage where the reward-risk structure is optimized.
Additionally, firms can enter the decline stage from any of the other stages. The
management literature documents a liability of newness phenomenon (Stinchcombe 1965;
Jovanovich 1982, Freeman, Carroll and Hannan 1983; Amit and Schoemaker 1993), which means
that variation in the level of initial endowments (monetary resources, technological or managerial
capability, etc.) interacts with mortality rates.
Therefore, firms in the decline stage are likely to
include very young firms that succumb to this high initial mortality rate. Additionally, firm life cycle
differs from firm age because firms of the same age can learn at different rates due to imperfections
in their feedback mechanisms (i.e., accounting quality). All of these factors result in a misalignment
between firm performance and firm age causing life cycle progression to be nonlinear in age. Taken
together, size and age should be maximized during the mature stage due to nonlinearity.
The first step of this paper is to validate whether the life cycle stages based on cash flow
patterns are consistent with economic theory with empirical analysis. Firms listed on the NYSE,
AMEX and NASDAQ exchanges (excluding ADRs) with necessary data on Compustat comprise
the sample.

The sample period extends from 1989 (the first year data from the Statement of Cash
Flows was available for all firms) through 2005. Firms with average net operating assets (NOA),
sales revenue, or market value of equity less than $1 million are excluded from the sample because
small denominators skew the profitability metrics used throughout the paper. Similarly, firms with
an absolute book value of equity less than $1 million are excluded from the sample. Firms in the
financial industries are excluded due to the unique nature of their cash flows. Firms with SIC codes

For example, Jovanovic (1982) presents an analytical model where firms hazard rates (probability of failure) initially
increase in the early life cycle stages.
greater than 9100 are omitted to ensure only for-profit firms are included in the sample. These
constraints result in a final sample of 48,369 firm-year observations.
If mature firms are stable, then the greatest frequency of observations will be present in this
category, while the lowest frequency of observations will be in the decline stage. Table 2 Panel A
confirms this prediction with 41 (five) percent of the firms classified as mature (decline). The effect
of firm life cycle on several economic characteristics is tested by regressing each economic
characteristic on indicator variables for life cycle membership, with the intercept capturing the
mature stage. The coefficients on introduction, growth, shake-out and decline are the effect on the
dependent variable relative to the mature stage.
[Insert Table 2 about here]
Economic theory predicts that profitability is maximized in the mature stage and this is
confirmed by the regressions on Earnings per Share (EPS) and Return on Net Operating Assets
(RNOA) (all coefficients except for mature are negative). The components of profitability, profit
margin and asset turnover, are a function of strategy and the competitive environment. For
example, Selling and Stickney (1989) point out that product-differentiating firms focus on research
and development, advertising, and capacity enlargement. These expenditures should result in a
higher profit margin (PM), which results confirm is maximized in the mature stage. Selling and
Stickney also indicate that as firms mature, competition becomes more intense and the emphasis
shifts to cost reduction and improved capacity utilization. This means that asset turnover ratios
(ATO) should increase in the mature stage, which is confirmed by the regression results (the
coefficient for growth firms is negative which indicates that asset turnover in the growth stage is
lower relative to the mature stage). The high level of ATO in the introduction stage may be due to
investments in uncapitalized assets such as research and development and/or operating leases.
Immediate expensing of these assets result in lower GAAP asset levels, which in turn depress ATO
(and RNOA) relative to mature stage firms.

Growth in sales (GrSALES) and capital investment (GrNOA) should monotonically
decrease across life cycle stages (Spence 1977, 1979, 1981), both of which are verified for
introduction through shake-out. Market-to-book (MB) is thought to proxy for both expected future
growth and risk. This suggests that mature firms should possess the lowest relative market-to-book
as compared with the tail observations and the results support this prediction. With respect to other
measures of risk, firms should make greater use of financial leverage (LEV) in the growth stage
(Myers 1984, Diamond 1991) and asset beta (ASSET BETA) (an unlevered measure of business
risk) should be minimized for mature firms. Dividends (DIVPAY) are more likely to be paid by
mature firms due to decreased investment opportunities. The results confirm the above for LEV,
Advertising intensity (ADVINT) and research and development (INNOV) should be
highest for early-stage firms as they build their initial technology. Both variables are highest in the
introduction stage (although decline firms appear to increase their research and development,
perhaps in a turnaround attempt). The number of segments (SEGMENTS) is expected to increase
through maturity as growth is executed via product and/or geographical expansion, which the
results confirm. Merger activity (MERGER) should be greatest for growth firms as they will likely
be targets for acquisition and results indicate that introduction and growth stages are where the
highest degree of activity takes place. Finally, size (SIZE) and age (AGE) are maximized for mature
stage firms consistent with life cycle being nonlinear in both of these variables. Cash flow patterns

I thank one of this papers reviewers for providing this insight.
result in a proxy that is representative of the economic theory underlying the life cycle

The preceding analysis is repeated for life cycle classifications based on Anthony and
Ramesh (1992) (Table 2, Panel B) and age quintiles (Table 2, Panel C). In Anthony and Ramesh
paper, the median values of dividend payout, sales growth, and capital expenditure (scaled by market
value) are computed over a five-year horizon. Those values, along with age are used to assign scores
to each observation.
Composite scores are used to form five equal-sized portfolios which they
label Growth, Growth/Mature, Mature, Mature/Stagnant, and Stagnant. Similarly, five equal-sized
portfolios are formed on firm age, designated as Young, Mid-Young, Middle, Mid-Old and Old.
In the last column of each panel, Vuong statistics are computed to compare the performance
of the cash flow patterns proxy to the Anthony and Ramesh (hereafter, AR) in Panel B and the age
quintile classifications in Panel C.
The cash flow patterns proxy significantly outperforms the AR
proxy for EPS, RNOA, PM, GrSALES, GrNOA, INNOV, and MERGER. All results hold for
cash flow patterns versus age with the exception of GrSALES.
Recall that the AR classification is the composite of sorts on sales growth, capital
expenditures, dividend payout, and age. As a result, AR provides better explanatory power for
DIVPAY and AGE (other components of ARs proxy). ARs measure is also more descriptive of

It is possible that the results reported in Table 2 are due to industry effects. If life cycle is actually an industry
phenomenon, then a simple industry control would capture the differences across firms. The economics literature
suggests industry life cycle patterns occur because the rate of innovation and intensity of competition change over the
industry life cycle. However, individual firms life cycle stages may differ within an industry because innovation is a
continuing process with firms entering and exiting the market throughout the entire industry life cycle. Furthermore, the
life cycle stages of individual firms within an industry vary due to differences in a firms knowledge acquisition, initial
investment and re-investment of capital, and adaptability to the competitive environment. All tests throughout the
paper were repeated on industry-adjusted samples based on the Fama French (1997) industry classifications (results
untabulated). In each case, the results were consistent with those reported throughout the paper. Therefore, firm life
cycle stage is distinct from industry life cycle.
Terciles of low to high dividend payout, high to low sales growth, high to low capital expenditure and young to old age
were given scores of one to three, respectively. The composite scores ranged from three to nine as in Anthony and
Ramesh (1992).
A positive (negative) Vuong statistic indicates that the cash flow patterns classification provides a better (worse) fit for
explaining each economic characteristic than does the alternative proxy.
ATO, MB, SEGMENTS and SIZE. To reconcile the differences in performance between the cash
flow patterns proxy and the AR classification, it should be pointed out that the cash flow patterns
capture the nonlinearity of earnings, RNOA, PM, level of sales (as opposed to sales growth), ATO,
age, etc. across the economically-defined life cycle stages. All of these variables are maximized in the
mature stage (i.e., an inverted-U shaped distribution). If profitability drives market performance,
then the cash flow proxy will be effective in predicting future performance from a profitability and
market perspective. Next, age quintiles outperform the cash flow proxy for the same set of
economic characteristics in which AR provided better explanatory power, which is expected since
age was a component of ARs measure. Since young firm contain both introduction and decline
firms, age provides less detail than the cash flow proxy with respect to low-performing firms.
Having validated the cash flow patterns proxy, in the next section I use the proxy to examine
the inter-temporal behavior of firms conditional on their initial life cycle stages. Survivorship bias is
an issue inherent in this type of analyses. Table 3 Panel A examines the proportion of firms that
survive for five years subsequent to the initial life cycle identification. To ensure a time span of five
years subsequent to initial identification, a reduced sample from 1989 to 2000 is used (the sample
period ends in 2005).
In the pooled sample, only 78 percent of firms survive five years ahead.
Possible reasons for absence include merger activity, going private, or bankruptcy. The proportion
of firms that delist for merger or performance-related issues are reported according to their life cycle
stage in the year prior to delisting, and this breakdown is displayed in the last two columns.

Delisting proportions by life cycle stage are significantly different from a uniform distribution across
life cycle stages (all z-statistics are significant). Over 65 percent of merger activity involves growth

Since one-year-ahead profitability is required for tests of explanatory power in Section 3, all firms survive through year
t + 1 by construction.
Cash flow data is insufficient for computing life cycle stage in the year in which the delisting takes place. Delisting
codes of 200-299 are categorized as Merger and codes of 500-599 are categorized as performance-related (Beaver,
McNichols and Price 2007).
or mature firms and over 68 percent of performance-related delistings involve introduction or
decline firms.
[Insert Table 3 about here]
The survivorship analysis is repeated by life cycle stage for the proportion of firms in
existence relative to the year of life cycle identification and z-statistics are computed on differences
in proportion between each life cycle stage and the pooled sample. The survival rates for mature
(decline) stage firms are significantly higher (lower) than the survival rates for the pooled sample in
all subsequent years. The introduction and growth firms are significantly lower than the pooled
sample for years t + 3 through t + 5.
Table 3 - Panel B examines the transition of firm-observations from one life cycle stage to
another in subsequent periods, again using the reduced sample to ensure five subsequent years from
the initial classification. The shaded portions of the table represent the proportion of firms that
remain in their initial stage in later periods. For example, 60.13 percent of mature firms remain in
the mature stage one year after initial classification. This proportion monotonically decreases to
55.97 percent by year t + 5. Several observations are worth noting from this analysis: (1)
introduction firms are likely to stay in introduction or to move to the growth or mature stage (over
80 percent of observations at end of five years), (2) growth firms are fairly stable but a large
proportion (ranging from 33.11 in year t + 1 and increasing to 43.23 percent by year t + 5) will
move to mature, (3) growth firms are not likely to move to decline (less than four percent are in
decline by year t + 5), (4) mature firms are stable and slightly less than 30 percent transition to
growth over the next five years, (5) movements from mature to decline are unlikely (only two
percent transition to decline during the five subsequent years), (6) a small proportion of decline
firms remain in decline (only 18 percent after five years), but movement to introduction (25 percent
by year 5) or to growth (23 percent), mature (20 percent) or shake-out (12 percent) is also fairly
common. Taken together, introduction firms tend to improve their position, growth and mature
firms are relatively stable, and decline firms (that survive) have unpredictable outcomes in
subsequent periods.

3. How can life cycle classification help us better understand future profitability?
Previous research documents that profitability measures mean-revert over time (Brooks and
Buckmaster 1976; Freeman, Ohlson and Penman 1982; Fairfield, Sweeney and Yohn 1996; Fama
and French 2000; Nissim and Penman 2001) and understanding the evolution of profitability
improves predictability. Stigler (1963) reported that profitability displayed a strong central tendency
over time, but that the convergence was incomplete. He stated that impediments to complete
convergence stem from disturbances related to shifts in demand, advances in technology, and
macroeconomic factors. Another potential impediment to convergence is differences in firm life
cycle stage.
Nissim and Penman (2001) suggest that truncated forecast horizons can be used if valuation
attributes settle down to permanent levels within the forecast horizon. Therefore, understanding
the convergence properties of profitability leads to better decisions with respect to growth rates and
forecast horizons. Specifically, if convergence properties differ across life cycle stages, this
information can be utilized to refine the valuation parameters for subsets of firms according to their
current life cycle stage.
[Insert Table 4 about here]
To examine the convergence characteristics of profitability by life cycle stage, Table 4
Panel A reports the mean of annual median values of RNOA examined over a five-year period
subsequent to the initial life cycle identification period. Pooled RNOA is relatively constant over
time, ranging from 8.30 to 9.12 percent. Likewise, the mature stage is characterized by stable
profitability with RNOA ranging between 10 and 11 percent. However, the RNOA of both
introduction and decline firms increase monotonically over time.
[Insert Figure 1 about here]
These medians are depicted graphically in Figure 1. Median RNOA by life cycle stage
partially converges by year 3, but the difference in median RNOA between mature firms (10.41
percent) and decline firms (3.26 percent) is quite distinct five years later (difference of 7.15 percent
which is substantial given that the median RNOA for the sample is 9.12 percent at time t). Growth
and shake-out firms have relatively stable RNOA over the subsequent five years but the level is
lower than that of mature firms. Indeed, mature firms maintain a sustainable advantage over the
other life cycle stages while introduction firms earn considerably less even after five years (10.41
percent for mature compared to 5.31 percent for introduction). Therefore, convergence of RNOA
remains incomplete at the end of five years, such that incorporating life cycle stage information will
substantially impact forecasts of future RNOA.
Next, I examine the frequency of RNOA decile membership by life cycle stage in Table 4
Panel B. Nissim and Penman (2001, Figure 4(b)) form deciles of RNOA and examine the
convergence of the deciles over five subsequent years to document how RNOA evolves over time.
They report a persistent difference in RNOA between the highest and lowest decile of RNOA after
five years. If those differences were attributable to firm life cycle, we would expect to see an
overrepresentation (underrepresentation) of introduction and decline (mature) firms in the lowest
RNOA deciles. Consistent with these expectations, Panel B shows that nearly two-thirds of
introduction firms (66 percent) and three-fourths of decline firms (78 percent) reside within the
lowest three deciles of RNOA. Comparatively, only 17 percent of mature firms are contained within
the lowest three RNOA deciles. Therefore, a partial explanation for the non-convergence in RNOA
in Nissim and Penmans study is attributable to differences in firm life cycle stage as measured by
cash flow patterns. Specifically, the mean-reversion of Nissim and Penmans lowest deciles of firms
is largely driven by the improvements in performance experienced by introduction firms and the
decline firms that survive in the future. However, the highest deciles (those shown to decline over-
time in Nissim and Penman) are not overpopulated by any one life cycle stage. Therefore, life cycle
theory better explains the mean-reversion properties of low-profitability firms than of high-
profitability firms.
Given the differences in RNOA by firm life cycle demonstrated in the previous analyses,
information about firm life cycle stage should be useful in explaining future profitability. I adapt
Fairfield and Yohns (2001) model of future profitability to test for the incremental effect of life
cycle stage in explaining one-year-ahead change in RNOA.
Current profitability (both level and
change in current RNOA) is included in the model because it is known to be serially correlated with
future profitability. The coefficients on current RNOA and RNOA are expected to be negative
since profitability is mean-reverting (Brooks and Buckmaster 1976; Freeman, Ohlson and Penman
1982; Fairfield and Yohn 2001). Future changes in profitability can also occur due to a denominator
effect, or growth in NOA. This growth, captured by GrNOA, is controlled for to ensure that the
changes in future profitability are not driven solely by changes in investment. Prior research has
shown the coefficient on GrNOA to be negative since investment in NOA is subject to diminishing
RNOA is decomposed into two components: asset turnover (ATO) and profit margin (PM).
Asset turnover indicates the amount of assets needed to generate sales whereas profit margin
indicates a firms ability to convert sales into profit. A cost leadership strategy is aimed at improving
the asset turnover, while a product differentiation strategy is oriented toward improving profit

Forecasts of future profitability are improved when based upon operating income rather than GAAP net income
(Fairfield, Sweeney and Yohn 1996; Nissim and Penman 2001). Therefore excluding the financing portion of the firm
focuses the analysis on the sustainability of operating profitability.
margin. Fairfield and Yohn (2001) examine the effect of both levels and changes in ATO and PM
on future change in RNOA.
Changes in ATO are indicative of increased efficiency in production
and should represent permanent sources of profitability such that a positive relation with future
profitability is expected (Penman and Zhang 2006, Fairfield and Yohn 2001). Penman and Zhang
(2006) find a negative relation between change in profit margin and future profitability. They
suggest that an increase in PM is derived from a current reduction in operating expenses, which is
not sustainable and thus has negative consequences for future profitability.
Next, I add alternative life cycle proxies (i.e., cash flow patterns, Anthony and Rameshs
classification, and age quintiles) to determine which classification scheme best explains future
profitability. Thus Model 1 is:
5 4 3 2 1 1
+ +
A + A + + A + + = A
t k
t t t t t t
| | | | | o
Because life cycle stages are captured by indicator variables set to one if the firm-observation
is a member in that stage, the intercept captures either mature firms (for cash flow patterns and the
AR classification) or middle-aged firms (for age quintiles).
The results of estimating Model 1 are
reported in Table 5. All standard errors reported throughout the analyses are robust with respect to
firm and year clustering. All of the profitability coefficients are significant (with the exception of
change in PM) and are in the predicted direction. For ease of comparison, all of the life cycle
coefficients are reported as the total effect (intercept + D
) but the t-statistics pertain to the
incremental difference between the each life cycle stage and the mature/mature/old stage.
[Insert Table 5 about here]

They report that current levels of ATO and PM are not informative in forecasting one-year-ahead change in RNOA
but that change in ATO is positively related to one-year-ahead change in RNOA.
The following alignments were made across classification schemes (cash flow patterns/AR/age quintiles):
Introduction/Growth/Young, Growth/Growth-Mature/Mid-Young, Mature/Mature/Middle, Shake-Out/Mature-
Stagnant/Mid-Old, and Decline/Stagnant/Old.
All cash flow pattern life cycle stage coefficients are significant with the mature stage
representing positive future change in profitability (t = 14.89). For brevity, only the cash flow
pattern life cycle stage names are used in Table 5, but I will include the alternative name in
parentheses when discussing the results for the AR and age quintile classifications. In the AR
classification, only the introduction (growth) stage was significantly and negatively related to future
change in profitability. Significant positive associations with future profitability are found for the
shake-out (mature/stagnant) and decline (stagnant) stages, which is counter to theory and intuition.
All age quintile life cycle stages, with the exception of mature (middle-aged), have a significant
association with one-year-ahead change in profitability, but again, the sign of the effect is counter to
economic theory. Therefore, life cycle stage as measured by cash flow patterns is most consistent
with theoretical expectations of future profitability. As a final check, Vuong statistics test the
validity of pairwise comparisons of the models for explaining RNOA
and the cash flow pattern
classification outperforms both the AR classification (z = 4.19) and the age quintile classification (z
= 3.89).
Recalling that Fairfield and Yohn (2001) found ATO to be informative for explaining
future profitability, economic theory suggests that mature firms should benefit the most from
improvements in efficiency (Spence 1977, 1977, 1981; Wernerfelt 1985). This occurs because
mature firms generate higher-than-normal profits, which attracts competition from other firms.
Thus, to continue to maintain profitability, mature firms need to refocus their operations on cost
containment and production efficiency. Selling and Stickney (1989) suggest that operational gains in
efficiency are reflected in improvements in ATO. Therefore, I predict that the explanatory power of
ATO for future profitability will be concentrated in mature firms (i.e., a positive coefficient on an
interaction term, Mature ATO).
Product differentiation efforts will be reflected in higher profit margins (Selling and Stickney
1989), and growth firms are likely to exert the greatest effort to establish their brand identity and
market share (Spence 1977, 1979, 1981). This suggests that growth firms will have the greatest
benefit in the future from current expenditures on product differentiation and thus I expect a
positive coefficient on an interaction between growth firms and change in PM, Growth PM.
However, given the results in Penman and Zhang (2006) that increases in profitability due to
increases in profit margin are not sustainable, I expect the incremental benefit of the product
differentiation strategy to be mitigated by the time a firm reaches maturity. This would indicate that
an interaction, Mature PM, would be negatively correlated with future changes in profitability.
To test these assertions, Model 2 is:

5 4 3 2 1 1
) ( ) (
= =
+ A + A +
+ A + A + + A + + = A

t k t
k k t
k t t t t t t
c o o
| | | | | o
Results from estimating Model 2 are reported in Table 5. As in Model 1, life cycle indicator
variables are included for the introduction, growth, shake-out, and decline stages whereas the mature
firms are captured through the intercept. The coefficients presented in Table 5 (Model 2) represent
the total effect (the main effect plus the incremental effect for each life cycle stage) on future change
in RNOA. However, reported tests of significance (t-statistics) pertain to whether the mature stage
coefficients are different from zero or in the case of the other life cycle stages, whether coefficients
are statistically different from those of mature stage firms.
As predicted, increases in ATO lead to significant increases in profitability primarily for
mature firms, but this effect is only captured by the cash flow patterns and age quintile
classifications. This result is consistent with economic theory stating that improving efficiency is
more important for mature firms once the market is saturated. Contrary to predictions, increases in
PM are not associated with increases in future RNOA for growth firms in any life cycle
However, consistent with predictions, the negative relation between changes in PM
and future profitability documented in Penman and Zhang (2006) is concentrated in the mature
stage for both the cash flow patterns and AR classifications.
Finally, Vuong tests of pairwise performance comparison indicate that the cash flow pattern
proxy outperforms the AR classification (z = 2.04) and slightly outperforms the age quintile
classification (z = 1.67) once the ATO and PM interactions are considered. Given the fact that both
the AR and age quintile classifications outperformed cash flow patterns when explaining ATO
(Table 2), it follows that the performance of cash flow patterns would decline once the ATO
interaction was included. Given the results of this analysis and the parsimony in computing the cash
flow pattern proxy relative to the AR classification, the cash flow patterns proxy better provides a
more tractable firm life cycle measure. Age is a parsimonious proxy, but young firms can be
distressed (Stinchcombe 1965; Jovanovich 1982; Freeman, Carroll and Hannan 1983; Amit and
Schoemaker 1993). While the Old classification may capture maturity, age does not provide a
distinct separation of introduction versus decline firms among the Young classification.
Cash outflows for research and development are included in the Statement of Cash Flows as
operating activities, but they are more representative of investing cash flows. For this reason, in an
untabulated analysis, the cash flow patterns specification for all analyses throughout the paper was
re-estimated with research and development reclassified as investing cash flows with no substantial
change in results from the results presented in the paper.

Some economics research claims that the benefits of product differentiation techniques such as advertising and
marketing are difficult to capture at the individual firm level because advertising partly serves to increase demand for the
entire market (Oster 1990, Shy 1995), i.e. there is a free-rider effect. Additionally, gains in innovation are difficult to
capture due to the mobility of labor among competing firms (Porter 1980, Jovanovic and Nyarko 1995). These factors
could mitigate the ability of product differentiation efforts to result in persistent increases in profitability.
4. What is the role of life cycle classification in understanding current firm value and
predicting future stock returns?

In previous sections, I have demonstrated that cash flow patterns provide a reliable and
parsimonious proxy for firm life cycle. Given the superior profitability of mature stage firms, this
life cycle attribute should be associated with higher buy-and-hold stock returns in future periods
conditional on a mature life cycle signal in the current period. Since the majority of firms are in the
mature stage at any given point (41.18 percent of the sample), investing upon seeing a mature life
cycle signal is easily implementable by all types of investors.
To examine whether investors recognize the persistent profitability of mature stage firms, I
examine 12-month buy-and-hold size-adjusted returns
computed by subtracting the appropriate
market capitalization decile return (from the CRSP database) from a firms raw return. Size-adjusted
returns are accumulated from the beginning of the fifth month of year t + 1 through the fourth
month of the second year following the life cycle stage signal (t + 2). This allows market
participants to assess life cycle stage based on the published financial statement data prior to
portfolio formation. Additionally, delisting returns are used when they are included in the CRSP
database and delisted firms without a corresponding delisting return are assumed to have a return of
zero (Piotroski 2000) unless the delisting occurred due to performance-related reasons in which case
the missing delisting return was set to -100.00 percent.

The independent variables used in the returns regression are earnings per share scaled by
stock price
(X/P) and change in earnings (X/P) because both earnings levels and changes have
significant explanatory power for annual stock returns (Easton and Harris 1991). Prior research has

The results are invariant in all analyses for replacing size-adjusted returns with market-adjusted returns.
Prior research has used -30.00 percent for NYSE and AMEX firms (Shumway 1997, Mohanram 2004) and -55.00
percent for NASDAQ firms (Shumway and Warther 1999) that are delisted for performance. Sloan (1996) uses -100.00
percent for performance-related delistings. Since missing delisting returns for mergers are likely to be understated when
setting to zero, I make no upward correction for merger-related missing returns to bias against finding results.
demonstrated a differential response to losses versus positive earnings (Hayn 1995, Basu 1997) so an
indicator variable (Loss) is set to one if the company incurs a loss for the current year and this
variable is included as a main effect and as an interaction with earnings. Common risk factors such
as the book-to-market ratio (B/M), size (Size) as measured by the natural log of the market value of
equity, and risk as captured by market model beta (Beta) (Collins and Kothari 1989, Fama and
French 1992) are included in the model, all scaled by beginning of the year stock price. Therefore,
Model 1 is estimated as:
1 , , 7 , 6
, 5 , 4 , 3 , 2 , 1 0 1 ,
/ ) / ( / /
+ +
+ + + + A + + =
t i t i t i
t i t i t i t i t i t i
Beta Size
M B Loss P X Loss P X P X RET
c | |
| | | | | o
Results from estimating Model 1 are reported in Table 6 and all coefficients are significant and
consistent with prior research. Standard errors used to compute significance are robust to clustering
by firm and year.
[Insert Table 6 about here]
In Model 2, an indicator variable capturing membership in the mature category is added to
the specification. The results from sections two and three indicate that the highest level of
profitability is attained and persists for mature firms (Figure 1). Investors may undervalue these
mature firms if they do not fully recognize the implications of the life cycle proxy (i.e., recognize the
signal of the cash flow patterns at the financial statement date) on firm value. If this potential
undervaluation is true, then the Mature variable should be positively associated with future size-
adjusted returns, which is demonstrated in Model 2 (t = 6.60) of Table 6.

Prior research has found that the book/market (B/M) ratio of a firm is strongly positively
correlated to future stock returns (Fama and French 1992, Lakonishok et al. 1994). Fama and

In untabulated results, Shake-Out firms were bundled with Mature firms since the level and persistence of profitability
of these two stages are fairly similar. This strengthened the magnitude and significance of the indicator variable.
Grouping growth firms with mature firms substantially weakened the results, which indicates that the returns-earnings
relation for growth firms is structurally different than that of mature and shake-out firms.
French attribute this result to risk due to the fact that high B/M firms may be closer to default. By
contrast, Lakonishok et al. attribute the B/M effect to mispricing such that investors are overly
optimistic about low B/M stocks (glamour firms) and pessimistic about value stocks (high B/M).
Piotroski (2000) and Mohanram (2005) investigate whether fundamental analysis can be used to
separate the winners from the losers at the two extremes of the B/M spectrum.
Piotroski develops an FSCORE based on nine binary variables (i.e., earnings versus loss,
increasing ROA, positive cash flows, cash flows greater than net income, increasing operating
margin, increasing asset turnover, decreasing leverage, increasing current ratio, and non-issuance of
equity) for value firms. Mohanram develops a GSCORE based on eight signals (i.e., ROA and cash
flows greater than median for other low B/M firms in the same industry, cash flows greater than net
income, lower earnings and sales growth variability than for other low B/M firms in industry, and
research and development, advertising intensity and capital expenditures all greater than other low
B/M in the same industry) for glamour firms. In both cases, partitioning on the respective
composite scores can identify firms where significant excess returns can be earned based on the ex
ante signal (FSCORE or GSCORE, along with the identification of low or high B/M). In
Piotroskis study, high B/M firms with the highest FSCORE earned mean market-adjusted returns
of 13.4 percent while high B/M firms with the lowest FSCORE earned -9.6 percent. Mohanram
found that low B/M firms with the highest GSCORE earned a mean size-adjusted return of 3.1
percent while the lowest GSCORE among low book/market firms earned -17.5 percent in the year
after portfolio formation.
It is possible that life cycle information (measured parsimoniously by cash flow patterns) can
effectively detect the upside of both the value and glamour trading strategies demonstrated in
Piotroskis and Mohanrams studies. Since most of the variables that comprised the FSCORE and
GSCORE are related to life cycle, especially as measured by cash flow patterns, the proxy used in
this paper may capture the essence of what makes the composite scores effective in predicting future
returns. Combining the B/M screen with the mature life cycle stage screen may identify firms that
comprised the long portion of the two B/M strategies. Furthermore, by restricting the B/M screen
to only mature firms, the necessity to short some firms is eliminated which makes the strategy highly
implementable for all types of investors.
Since market participants have access to more information than what is captured by the
accounting system, a high market value relative to book value (resulting in low B/M) may be
reflective of future product development. In other words, mature firms that have low B/M ratios
(mature-glamour firms) may be on the cusp of recycling back to the growth life cycle stage in future
periods due to new product or market expansions. If the new development is successful, those
firms should enjoy increasing profitability as the new development matures.
Conversely, a low market value relative to book value (high B/M) is indicative of market
inattention or neglect by information intermediaries such as analysts. When high B/M firms are also
mature (mature-value firms), the risk of distress is much lower than stocks that are avoided due to
anticipation of poor performance. It has been demonstrated that these types of value stocks are
undervalued by the market which may result in a positive reaction when the market realizes their
profitability did not mean-revert to lower expectations. Therefore, Model 3 examines whether
interacting the mature life cycle stage with alternatively the lowest and highest quintiles of B/M
results in positive size-adjusted returns in the year following the mature and B/M signal:
1 , , 10
, 9 , 8 , 7 , 6
, 5 , 4 , 3 , 2 , 1 0 1 ,
) / (
) / (
/ ) / ( / /
+ + + +
+ + + + A + + =
t i t i
t i t i t i t i
t i t i t i t i t i t i
M HighB Mature
M LowB Mature Mature Beta Size
M B Loss P X Loss P X P X RET
c |
| | | |
| | | | | o
Results show that the interactions between Mature and both the lowest and highest quintiles
of B/M generate positive size-adjusted returns in the year after portfolio formation (t = 3.05 and t =
2.16, respectively). Overall, the mispricing based on extreme values of B/M demonstrated in prior
research is likely to be more severe among mature firms, consistent with the market not recognizing
the level and persistence of RNOA in these firms. Furthermore, there are ample observations in the
Mature-Low B/M quintile portfolio (ranging from 104 firms in 2000 to 256 firms in 2003) and in
the Mature-High B/M quintile portfolio (ranging from 180 firms in 1989 to 295 firms in 2002) to
comprise an economically meaningful investment portfolio to exploit this mispricing in any given

5. Conclusion
This paper develops and validates the use of cash flow patterns as an effective and
parsimonious proxy for firm life cycle. Several performance measures and firm characteristics such
as profitability, market performance, size, and age are nonlinearly related to firm life cycle. For that
reason, univariate sorts on these performance measures result in an inappropriate assignment of life
cycle stages such that the lowest portfolios are populated with both introduction and decline firms,
which have differential implications for future performance. More importantly, a simple sort on
univariate measures makes a distributional assumption of uniformity that is not supported by
economic theory.
The paper first validates the life cycle proxy according to economic theory and then
examines how cash flow patterns capture the economic concept of life cycle relative to proxies used
in past research (i.e., Anthony and Rameshs metric and firm age). Next, the persistence of
profitability, measured by return on net operating assets (RNOA) is examined by life cycle stage.
Convergence rates and the patterns of mean-reversion of future profitability are shown to differ by
life cycle stage. Specifically, the spread in RNOA is three to 10 percent between mature and decline
firms five years subsequent to portfolio formation (based on life cycle identification). This spread of
seven percent is economically significant given that the median RNOA for the sample is 8.61
percent. The valuation and forecasting implications are that growth rates and forecast horizons
should be conditioned on information pertaining to the firms current life cycle stage.
Additionally, past research on the decomposition of RNOA has shown that change in asset
turnover is an important driver of future changes in RNOA (Fairfield and Yohn 2001) but that
improvements in future profitability due to increases in profit margin are not sustainable (Penman
and Zhang 2006). Both of these results are primarily concentrated in mature firms. Increases in
operational efficiency are critical for mature firms due to increased competition that is attracted to
the superior profits earned by mature firms. At the same time, diminishing returns to product
differentiation efforts appear to be evident among those same firms.
Finally, the market valuation consequences of life cycle (as captured by cash flow patterns)
are investigated and it is demonstrated that positive future excess returns can be earned for firms
that fall into the mature category. Furthermore, life cycle adds crucial fundamental information to
separate out the winners from the losers at both extremes of the book/market spectrum (i.e.,
glamour and value firms). The cash flow pattern proxy captures information priced by the market in
a more efficient manner than the fundamental signals used in previous trading strategies which
require the computation of composite scores based on numerous metrics.
In summary, this paper uses basic accounting information to capture the construct of firm
life cycle which embodies differences in resources, rates of investment, obsolescence rates, learning
and experience curves, adaptation, product-differentiation, and production efficiencies. The cash
flow pattern proxy for life cycle stage outperforms other proxies used in extant research including
age, and better explains future profitability (both in rates of return and stock returns) given its
foundation in economic theory.


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Table 1
Economic Links to Cash Flow Patterns
Cash Flow
Introduction Growth Mature Shake-Out Decline
Firms enter market with
knowledge deficit about
potential revenues and
costs (Jovanovic 1982)

() Cash Flows
Profit margins are
maximized during
period of greatest
investment (Spence
1977, 1979, 1981)

(+) Cash Flows
Efficiency maximized
through increased
knowledge of
operations (Spence
1977, 1979, 1981;
Wernerfelt 1985)

(+) Cash Flows

Declining growth rates
lead to declining prices
(Wernerfelt 1985)
Routines of established
firms hinder competitive
flexibility (Hannan and
Freeman 1984)

(+/) Cash Flows
Declining growth rates
lead to declining prices
(Wernerfelt 1985)

() Cash Flows

Managerial optimism
drives investment
(Jovanovic 1982)
Firms make early large
investments to deter
entry (Spence 1977,
1979, 1981)

() Cash Flows
Firms make early large
investments to deter
entry (Spence 1977,
1979, 1981)

() Cash Flows
increases relative to
new investment as
firms mature
(Jovanovic 1982,
Wernerfelt 1985)

() Cash Flows
Void in theory

(+/) Cash Flows
Liquidation of assets
to service debt

(+) Cash Flows

Pecking order theory
states firms will access
bank debt then equity
(Myers 1984, Diamond
1991); Growth firms
will issue short-term
debt (Barclay and Smith

(+) Cash Flows
Pecking order theory
states firms will access
bank debt then equity
(Myers 1984, Diamond
1991); Growth firms
will issue short-term
debt (Barclay and Smith

(+) Cash Flows
Focus shifts from
acquiring financing to
servicing debt and
distributing excess
funds to shareholders;
Mature firms will issue
longer term debt
(Barclay and Smith
() Cash Flows
Void in theory

(+/) Cash Flows
Focus on debt
repayment and/or
renegotiation of debt

(+/) Cash Flows
Table 2
Effect of Life Cycle Classification on Economic Characteristics

Panel A Life Cycle Stages defined by Cash Flow Patterns
Pooled Introduction Growth Mature

N 48,369 5,752 16,423 19,920 3,861 2,413
% of total N 100.00% 11.89% 33.95% 41.18% 7.98% 4.99%
Coefficients (relative to Mature)

EPS 0.61
RNOA 8.61%
PM 4.57%
ATO 1.95
GrSALES 9.97%
GrNOA 7.28%
MB 1.91
LEV 0.19
DIVPAY 15.38%
ADVINT 0.98%
INNOV 4.97%
MERGER 17.70%
SIZE 5.39
AGE 10.43

Table 2 - Continued
Effect of Life Cycle Classification on Economic Characteristics

Panel B Life Cycle Stages defined by Anthony and Ramesh Classification
Growth Gr/Mat Mature Mat/Stag Stagnant
N 8,169 7,135 7,814 7,640 11,527 CF Patt.
% of total N 19.32% 16.87% 18.48% 18.07% 27.26%
over AR
Coefficients (relative to Mature)

.0909 6.28
.1778 37.27
.0231 36.51
.0077 -9.33
.0415 4.11
.0228 13.32
.0096 -5.15
.0097 1.54
.0186 -3.19
.1193 -26.77
.0011 1.61
.0190 19.41
.0846 -25.39
.0097 12.68
.0883 -9.45
.4676 -104.03

Table 2 - Continued
Effect of Life Cycle Classification on Economic Characteristics

Panel C Life Cycle Stages defined by Age Quintiles
Young Mid/Young Middle Mid/Old Old
N 9,705 9,647 9,641 9,725 9,651 CF Patt.
% of total N 20.06% 19.94% 19.93% 20.11% 19.95%
over Age
Coefficients (relative to Mature)

.1001 6.98
.0296 36.30
.0346 35.74
.0093 -8.57
.0599 -1.34
.0368 7.11
.0080 -2.05
.0122 1.19
.0183 -1.27
.0682 -14.51
.0032 -1.39
.0243 19.33
.0846 -30.89
.0115 11.71
.1110 -12.92
.7932 -221.89

Table 2 - Continued
Effect of Life Cycle Classification on Economic Characteristics

For the sample period 1989 to 2005. Means presented in Panel A are the means of annual medians except for total number of
observations, dividend payout ratio, advertising, innovation, number of segments, and mergers which are annual means. The
explanatory power of each life cycle classification is tested by regression each dependent variable on indicator variables for each life
cycle stage except for Mature (Middle) which is captured in the intercept. This means that the regression coefficients capture the
effect of each life cycle stage relative to maturity. Robust standard errors are clustered by firm and year. Coefficients significant at the
0.05 level or better are designated in bold. Vuong statistics report the explanatory power of the Cash Flow Pattern classification over
Anthony and Rameshs (Age Quintiles) classification in Panel B (Panel C). Dependent variables are measured as follows: Earnings
per share (EPS) is measured before extraordinary items (#58). Return on net operating assets (RNOA) = Operating Income
(OIt)/Average Net Operating Assets (NOA). Profit margin (PM) = Operating Income (OI)/Net sales (#12). Asset Turnover (ATO)
= Net Sales)/Average Net Operating Assets (NOA). Growth in Sales (GrSALES) is defined as (Net Sales/Lagged Net Salest) 1.
Growth in NOA (GrNOA) is defined as (NOA/NOA) 1. Market-to-Book (MB) = Market Value of Equity/Book Value of Equity
(#60). Leverage (LEV) = Net Financial Obligation/Common Equity (#60). ASSET BETA is the mean market model beta from a
regression of daily raw returns on the value-weighted market return over the prior 250 days adjusted for leverage. Dividend Payout
Ratio (DIVPAY) = Common dividends (#21)/Net Income (#172). Advertising Intensity (ADVINT) is Advertising Expense (#15)
/Net Sales (#12), Innovation (INNOV) is [R&D (#46) plus Amortization Expense (#65)/Net Sales (#12)]. SEGMENT is the
number of segments reported in the Compustat segment files. MERGER is the percentage of firms that have AA codes in
Compustat (AFTNT1). SIZE is the log of market value of equity. AGE is defined as the log of the number of years since the firms
first appearance in the CRSP database. All variables are winsorized at the 1st and 99
percentiles to mitigate the influence of extreme

Table 3
Survival Rate and Transition Matrix Analyses

Panel A Proportion of firms that survive beyond portfolio formation period
N = 33,088

Stage at
Formation t+1 t+2 t+3 t+4 t+5
Pooled 100.00% 93.45% 87.74% 82.77% 78.15%

Introduction 100.00 93.11 86.70 81.36 76.44 15.30 41.53
z-stat - 0.796 1.887 2.230
2.477 4.615 15.008

Growth 100.00 92.98 86.84 81.53 76.95 32.04 11.98
z-stat - 1.732 2.518 3.020
2.677 9.640 6.858

Mature 100.00 94.26 89.20 84.75 80.33 33.79 7.78
z-stat - 3.233 4.401 5.179
5.198 10.382 10.891

Shake-Out 100.00 92.82 87.17 82.07 76.59 10.87 11.68
z-stat - 1.161 0.790 0.849
1.760 8.753 7.820

Decline 100.00 91.74 85.42 79.45 75.14 8.01 27.03
z-stat - 2.459 2.536 3.167
2.624 12.186 5.183

Base years range from 1989 to 2000 so that five subsequent years are available for each observation (sample period extends to 2005).
Z-statistics (in italics below the proportion) from a test of equal proportions is computed for each life cycle stage relative to the
pooled sample for the years subsequent to life cycle identification; and for each stage relative to a uniform distribution for the
delisting categories. Z-Statistics in bold indicate a significant difference in proportions at 0.05 significance level or better. Delisting
data was extracted from the CRSP Event database and was computed for all observations with adequate cash flow data to compute
the life cycle stage in the year prior to delisting. CRSP categorizes delistings as follows: 200-299 are mergers and 500-599 are
dropped securities due to performance. The proportion of delistings due to mergers (inadequate performance) is computed by life
cycle stage and reported in the second to the last (last) column.

Table 3 Continued
Survival Rate and Transition Matrix Analyses

Panel B Transition Matrix: Proportion of observations in each life cycle stage in years subsequent
to portfolio formation
N = 33,088

Stage at
Stage in
Period t+1 t+2 t+3 t+4 t+5

Introduction Introduction 36.93 30.11 27.48 26.21 23.66
Growth 22.46 23.64 25.75 27.58 27.73
Mature 19.72 23.80 25.33 27.26 29.13
Shake-Out 8.28 8.82 8.50 8.04 8.43
Decline 12.61 13.62 12.94 10.90 11.07
Growth Introduction 7.71 6.84 6.30 6.26 5.89
Growth 51.39 45.06 42.47 40.92 38.66
Mature 33.11 38.27 40.71 41.82 43.23
Shake-Out 5.72 7.36 7.45 7.85 8.66
Decline 2.07 2.47 3.07 3.15 3.55
Mature Introduction 4.44 5.07 5.24 5.10 4.98
Growth 27.68 29.07 28.42 28.58 28.85
Mature 60.13 57.02 56.63 56.13 55.97
Shake-Out 6.11 7.03 7.78 8.17 8.13
Decline 1.64 1.81 1.94 2.01 2.07
Shake-Out Introduction 10.07 9.53 10.02 10.26 9.35
Growth 22.99 25.30 26.62 25.46 28.17
Mature 41.57 41.80 42.89 43.85 43.72
Shake-Out 18.41 16.09 14.07 13.31 12.78
Decline 6.96 7.28 6.39 7.11 5.98
Decline Introduction 28.18 29.04 28.91 26.23 25.83
Growth 14.16 17.03 20.24 19.69 23.36
Mature 16.78 18.76 19.39 22.50 20.31
Shake-Out 13.07 11.30 11.31 11.25 12.49
Decline 27.81 23.86 20.15 20.33 18.02

Base years range from 1989 to 2000 so that five subsequent years are available for each observation (sample period extends to 2005).
For each life cycle stage at the time of portfolio formation (year t), this table reports the proportion of surviving firms by life cycle
stage for each year subsequent to life cycle identification.

Table 4
Analysis of Return on Net Operating Assets (RNOA) by Life Cycle Stage

Panel A Inter-temporal Analysis of Median RNOA by Life Cycle Stage
Pooled Introduction Growth Mature
N 33,088 4,121 11,742 13,424 2,409 1,392
% of total N 100.00% 12.45% 35.49% 40.57% 7.28% 4.21%
Year Relative to

t 9.12% -4.18% 9.54% 11.01% 8.26% -16.30%
t + 1 8.53% -1.75% 8.38% 10.74% 7.85% -9.08%
t + 2 8.30% 1.30% 7.86% 10.34% 7.96% -4.86%
t + 3 8.43% 3.15% 7.84% 10.27% 8.37% 0.30%
t + 4 8.71% 4.56% 8.03% 10.50% 8.60% 0.59%
t + 5 8.93% 5.31% 8.19% 10.41% 9.45% 3.26%

Panel B Proportion of Life Cycle Stage by RNOA Decile Membership
Pooled Introduction Growth Mature
N 48,369 5,752 16,423 19,920 3,861 2,413
% of total N 100.00% 11.89% 33.95% 41.18% 7.98% 4.99%
RNOA Decile
Lowest 35.95% 3.57% 2.44% 12.04% 50.73%
2 19.66% 8.32% 6.57% 14.69% 19.31%
3 10.57% 10.97% 8.92% 12.04% 7.67%
4 7.09% 11.54% 10.48% 8.70% 4.68%
5 5.49% 11.70% 11.31% 7.10% 2.86%
6 5.09% 11.37% 11.71% 7.46% 2.49%
7 5.18% 10.91% 12.08% 7.80% 1.82%
8 4.73% 9.89% 12.86% 7.93% 2.98%
9 3.76% 10.13% 12.73% 9.35% 2.69%
Highest 2.47% 11.59% 10.90% 12.90% 4.77%
Total 100.00% 100.00% 100.00% 100.00% 100.00%
Likelihood Ratio Chi-Square: 11,311.17 (<.0001)
Table 4 - Continued
Analysis of Return on Net Operating Assets (RNOA) by Life Cycle Stage

The sample period is 1989 to 2000 for Panel A and from 1989 to 2005 for Panel B. Panel A requires five subsequent years to
portfolio formation to ensure that the results are not affected by a truncated time period. Return on net operating assets (RNOA) is
the mean of the annual medians and is measured as Operating Income (OIt)/Average Net Operating Assets (NOA). In Panel B, life
cycle stage membership is analyzed as a proportion of RNOA decile membership. A test of equal proportions across RNOA deciles
by life cycle stage was rejected with a Likelihood Ratio Chi-Square of 11,311.17 (<0.0001).

Table 5
Explanatory Power of Life Cycle Stages for Future Change in RNOA

n = 48,369
CF Patt. A&R Age Quintiles
Model 1 Model 2 Model 1 Model 2 Model 1 Model 2












Growth +/
Mature +
Shake-Out +/

Intro ATO



Growth ATO


Mature ATO +


Shake-Out ATO


Decline ATO


Intro PM



Growth PM +


Mature PM



Shake-Out PM


Decline PM


Adj. R-sq. 16.54% 16.65% 16.09% 16.27% 16.08% 16.23%

Vuong test comparing: Model 1 Model 2
Z-Statistic p-value Z-Statistic p-value
CF Patterns over A&R: 4.19 <0.0001 2.04 0.0417
CF Patterns over Age: 3.89 <0.0001 1.67 0.0947

Table 5 Continued
Explanatory Power of Life Cycle Stages for Future Change in RNOA

For the sample period 1989 to 2005. Robust standard errors are clustered by firm and year. The dependent variable is RNOAt+1.
The coefficients are the total effect (the main effect plus the incremental effect for each life cycle stage). The t-statistics pertain to
whether the mature stage coefficients are different from zero or whether the other life cycle coefficients are statistically different from
the mature stage coefficient.
The following alignments were made across classification schemes (cash flow patterns/AR/age quintiles):
Introduction/Growth/Young, Growth/Growth-Mature/Mid-Young, Mature/Mature/Middle, Shake-Out/Mature-Stagnant/Mid-
Old, and Decline/Stagnant/Old.
Return on net operating assets (RNOA) = Operating Income (OIt)/Average Net Operating Assets (NOA). Growth in NOA
(GrNOA) is defined as (NOA/Lagged NOA) 1. Asset turnover (ATO) = Net sales (Compustat #12)/Average Net Operating
Assets (NOA). Profit margin (PM) = Operating Income (OI)/Net sales (#12). All variables are winsorized at the 1st and 99

percentiles to mitigate the influence of extreme values.

Table 6
Buy-and-Hold Annual Size-Adjusted Returns to Life Cycle Strategy

n = 46,226
Variable Predicted Sign

Model 1 Model 2 Model 3
Intercept +/
X/P +
X/P +
Loss +/
X/P Loss




Low B/M


High B/M


Adj. R-sq. 1.15% 1.23% 1.25%

For the sample period 1989 to 2005. Robust standard errors are clustered by firm and year. This table presents 12-month buy-and-
hold size-adjusted returns accumulated from the beginning of the fifth month of year t + 1 through the fourth month of year t + 2.
Portfolio formation is based on life cycle stage or book-to-market ratio at the end of year t. Delisting returns are used when included
in the CRSP database. Delisted firms without a corresponding delisting return are assumed to have a return of -100 percent in the
delisting period when delisted for performance-related reasons (Delisting codes between 200 and 299); zero percent otherwise.
Earning/Price (X/P) are earnings per share before extraordinary items scaled by beginning of the year stock price. Loss is an
indicator variable set to one if earnings are negative in the current year. Book-to-Market (B/M) = [Book Value of Equity (#60) /
Market Value of Equity] scaled by beginning of the year stock price. SIZE is the log of market value of equity scaled by beginning of
the year stock price. BETA is the mean market model beta from a regression of daily raw returns on the value-weighted market
return over the prior 250 days scaled by beginning of the year stock price. MATURE is an indicator variable set to one if the
observation is in the mature category (based on cash flow patterns) at the end of the year. Low (High) B/M is the lowest (highest)
quintile of the B/M ratio at the end of the year. All variables are winsorized at the 1st and 99
percentiles to mitigate the influence of
extreme values.

Figure 1
Convergence Analysis - Future RNOA by Life Cycle Stage


For the sample period 1989 to 2000. Life cycle stage is determined at time zero and median RNOA for each stage is computed for
the five subsequent years.

0 1 2 3 4 5


Year Relative to Portfolio Formation Year
Introduction Growth Mature Shake Out Decline