Earnings volatility, cash flow volatility, and firm value

George Allayannis1 Darden Graduate School of Business, University of Virginia PO Box 6 !, "harlottesville, VA ##$!6 %&'&( $#&)'&'&, allayannisy*darden+virginia+edu Brian ,ountree -ones Graduate School of .anage/ent ,ice University 61!! .ain Street, 0ouston 12 33!! %31'( '&4) '#4, rountree*rice+edu -a/es P+ 5eston -ones Graduate School of .anage/ent ,ice University 61!! .ain Street, 0ouston 12 33!! %31'( '&4)&&4!, 6eston7*rice+edu 1his version8 Dece/9er #!!

5e 6ould li:e to than: -ennifer Blouin, Susan "ha;lins:y, <en =ades, Gustavo Grullon, .i:e >e//on, Bernadette .inton, 1ho/as .oeller, <aren ?elson and se/inar ;artici;ants at .cGill University and the University of Utah for their /any hel;ful suggestions+ 1he first author also 6ishes to than: the Darden School @oundation and the Batten Anstitute for su//er su;;ort and the third author a research fello6shi; fro/ the Batten Anstitute+

A9stract
1his ;a;er ;resents e/;irical evidence that cash flo6 volatility is negatively valued 9y investors+ 1he /agnitude of the effect is su9stantial 6ith a one standard deviation increase in cash flo6 volatility resulting in a;;roxi/ately a '# ;ercent decrease in fir/ value+ 5e fail to docu/ent an increase in value associated 6ith earnings s/oothing resulting fro/ /anagersB accrual esti/ates+ Our results are consistent 6ith ris: /anage/ent theory and suggest that /anagersC efforts to ;roduce s/ooth financial state/ents /ay add value to the fir/, 9ut only via the cash co/;onent of earnings+

Antroduction
"or;orate ris: /anage/ent theory argues that shareholders are 9etter off if a fir/ /aintains s/ooth cash flo6s+ @or exa/;le, @root, Scharfstein, and Stein %1$$'( argue that s/ooth cash flo6s can add value 9y reducing a fir/Cs reliance on costly external finance+# =/;irically, .inton and Schrand %1$$$( sho6 that cash flo6 volatility is costly as it affects a fir/Cs invest/ent ;olicy 9y increasing 9oth the li:elihood and the costs of raising external ca;ital+' One recurring the/e in this literature is that, ceteris ;ari9us, fir/s 6ith s/oother financial state/ents should 9e /ore highly valued+ 5hile ;revious research finds that cash flo6 volatility is costly, no direct evidence exists lin:ing financial state/ent volatility to fir/ value+ Such a lin: is i/;ortant 9ecause, in order for ris: /anage/ent to /atter, s/ooth financials /ust 9e valued at a ;re/iu/ to /ore volatile ones+ An this ;a;er, 6e test the hy;othesis that investors value fir/s 6ith s/ooth cash flo6s at a ;re/iu/ relative to fir/s 6ith /ore volatile cash flo6s+ "onsistent 6ith ris: /anage/ent theory, 6e find strong evidence that cash flo6 volatility is negatively related to ;roxies for fir/ value+ Given investorsC, analystsC, and /anagersC a;;arent focus on earnings, rather than cash flo6s, 6e further investigate 6hether earnings volatility also ;lays a role as a signal of financial s/oothness, in addition to cash flo6 volatility+ 1here are a nu/9er of reasons 6hy earnings volatility /ay /atter to the fir/, inde;endent of cash flo6 volatility+ @or
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See also earlier related 6or: 9y Sha;iro and 1it/an %1$46(, >essard %1$$!(, and StulD %1$$!(+ See GecDy, .inton, and Schrand %1$$3( for e/;irical evidence consistent 6ith the @root, Scharfstein, and Stein %1$$'( theoryE and ?ance, S/ith, and S/ithson %1$$'(, 1ufano %1$$6(, .ian %1$$6(, 0aushalter %#!!!(, Bro6n %#!!1(, and Graha/ and ,ogers %#!!#( for e/;irical evidence su;;ortive of alternative ris: /anage/ent theories ' =arlier related 6or: docu/ents an inverse relation 9et6een invest/ent and financial liFuidity %see+, e+g+, @aDDari, 0u99ard, and Petersen %1$44(E <a;lan and Gingales %1$$3(E and >a/ont %1$$3((

exa/;le, ;rior e/;irical 6or: suggests that analysts tend to avoid covering fir/s 6ith volatile earnings, as it increases the li:elihood of forecast errors %see, e+g+, Brennan and 0ughes %1$$1(, and Schi;;er %1$$1((+& Si/ilarly, Badrinath, Gay, and <ale %1$4$( find that institutional investors avoid co/;anies that ex;erience large variations in earnings+ 0igh earnings volatility also increases the li:elihood of negative earnings sur;risesE in res;onse, /anagers have engaged in extensive earnings s/oothing+ 1rue/an and 1it/an %1$44( suggest that earnings s/oothing reduces a fir/Cs ;erceived ;ro9a9ility of default and therefore a fir/Cs 9orro6ing costs+ Goel and 1ha:or %#!!'( suggest that a fir/ /ay s/ooth earnings so as to reduce the infor/ational advantage of infor/ed investors over uninfor/ed investors, and therefore ;rotect these investors 6ho /ay need to trade for liFuidity reasons+ @inally, @rancis, >afond, Olsen, and Schi;;er %#!!&( find fir/s 6ith greater earnings s/oothing have a lo6er cost of ca;ital even after accounting for cash flo6 volatility+ An this ;a;er, 6e exa/ine 6hether earnings volatility is also negatively associated 6ith fir/ value, in addition to cash flo6 volatility+ Our results indicate the /ar:et does not value earnings s/oothing 9ehavior after accounting for the volatility in the underlying cash flo6s+ An fact, under certain s;ecifications the /ar:et a;;ears to ;unish fir/s for underta:ing s/oothing 9ehavior ;referring earnings volatility /irror cash flo6

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Although Barth, <asDni:, and .c?ichols %1$$$( argue that analyst follo6ing could 9e greater for highly volatile stoc:s, as these are the stoc:s for 6hich analysts can ;otentially add /ore value through coverage and hence stand to 9enefit /ore+ >o6 analyst coverage is associated 6ith lo6er value due to higher infor/ation asy//etries %see e+g+, .erton %1$43( for theoretical argu/ent, and >ang, >ins, and .iller %#!!'(, a/ong others, for e/;irical evidence+( =arly 6or: in the accounting literature docu/ented a negative stoc: ;rice reaction u;on announce/ents of changes in accounting rules ex;ected to increase earnings volatility %see, e+g+, "ollins, ,oDeff, and Dhali6al %1$41(, and >ys %1$4&((+ .ore recently, Genner %#!!1( using a si/ulation a;;roach sho6s that a reduction in earnings volatility fro/ 4 H to #!H increases fir/ value 9y roughly &+ H+ @inally, 0unt, .oyer, and Shevlin %#!!!( suggest that s/oothing results in higher /ulti;les on re;orted earnings and 1ho/as and Ghang %#!!#( find that s/oothing generates higher for6ard PI= ratios+

volatility+ 1hese results are i/;ortant and suggest /anagers focus their actions on s/oothing cash flo6s rather than necessarily utiliDing accruals to s/ooth earnings+ Of course, there are a nu/9er of other 6ays in 6hich financial uncertainty interacts 6ith fir/ value+ According to the "AP., syste/atic ris: should 9e negatively related to value, since higher discount rates yield a lo6er value, ceteris ;ari9us+ @urther, recent e/;irical 6or: suggests that not only does syste/atic ris: affect value, 9ut also idiosyncratic ris: /ay 9e ;riced %Shin and StulD, #!!!(+ 5e find a negative relation 9et6een syste/atic ris: and fir/ value, as 6ell as a negative and significant association 9et6een unsyste/atic ris: and fir/ value+6 Our ;a;er further contri9utes to the literature 9y focusing on the value effect of t6o alternative ty;es of ris:, na/ely, cash flo6 and earnings volatility+ 1hese /easures are of ;ri/ary i/;ortance since unli:e financial /ar:et varia9les they reflect the actual sta9ility of the fir/sC financial state/ents and are directly affected 9y /anagerial decisions and the fir/sC ris: /anage/ent ;olicies+ Using a large sa/;le of non)financial fir/s, 6e ;resent evidence that cash flo6 volatility is negatively and significantly associated 6ith 1o9inCs J utiliDing the /ar:et)to) 9oo: ratio as a ;roxy+ 1he /agnitude of the effect varies across different tests, 9ut is al6ays large+ S;ecifically, 6e find that a one standard deviation increase in cash flo6 volatility is associated 6ith a '!)'3 ;ercent reduction in fir/ value+ Our results are ro9ust to various sets of control varia9les, esti/ation techniFues, su9);eriods, su9)sa/;les, and to a nu/9er of different /ethods for esti/ating earnings and cash flo6 volatility+ Although 6e find that cash flo6 volatility has a negative effect on fir/ value in all of our tests, 6e are una9le to find a si/ilarly negative effect for earnings volatility at
6

1he negative association 9et6een idiosyncratic ris: and fir/ value ;arallels recent asset ;ricing literature, 6hich finds evidence that idiosyncratic ris: /atters %see, e+g+, Green and ,ydFuist %1$$3(, Goyal and Santa "lara %#!!'(, and .al:iel and 2u %#!!#((

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the sa/e ti/e+ 1hese results are ro9ust to several alternative /easures of earnings volatility as 6ell as /ore direct /easures of earnings s/oothing li:e the ratio of earnings volatility to cash flo6 volatility and the association 9et6een conte/;oraneous changes in accruals and changes in cash flo6s %>euD et al+ %#!!'((+ 1hese findings are inconsistent 6ith the /ar:et valuing earnings s/oothing 9ehavior via accrual /anage/ent, and instead indicate value fro/ any earnings s/oothing activities ste/s fro/ /anage/ent of the cash flo6 co/;onent of earnings+ 1he re/ainder of the article is organiDed as follo6s+ Section 1 descri9es our sa/;le and develo;s our hy;othesis+ Section # ;resents our e/;irical /ethodology and the tests of the relation 9et6een earnings and cash flo6 volatility and fir/ value+ Section ' exa/ines the ro9ustness of our e/;irical results and Section & concludes+ 1. Sample Description and Hypothesis Development 1.1 Related Literature and Hypothesis Development Prior e/;irical research in ris: /anage/ent has ans6ered a series of i/;ortant Fuestions+ @or exa/;le, ?ance, S/ith and S/ithson %1$$'(, 1ufano %1$$6(, .ian %1$$6(, GecDy, .inton, and Schrand %1$$3(, 0aushalter %#!!!(, Bro6n %#!!1(, and Graha/ and ,ogers %#!!#(, a/ong others, have exa/ined currency, interest rate, and co//odity hedging activities 9y fir/s across industries or 6ithin a ;articular industry and the extent to 6hich these activities are consistent 6ith existing hedging theories %e+g+, StulD %1$4&(, S/ith and StulD %1$4 (, @root et al %1$$'(, De.arDo and Duffe %1$$ (, >eland %1$$4(, etc+(+ ,elated 6or: has exa/ined alternative hedging ;ractices, such as the use and relationshi; of financial derivatives and accrual /anage/ent %Barton %#!!1((+

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Another /ore recent strand of the literature has focused on lin:ing hedging activities to fir/ value and on exa/ining the 9asic ;re/ise 9ehind hedging, na/ely that the volatility of cash flo6 is costly for fir/s+ @or exa/;le, Allayannis and 5eston %#!!1( find that the use of currency derivatives, a ;roxy for hedging, i/;roves value su9stantially+ Si/ilarly, .inton and Schrand %1$$$( find evidence that cash flo6 volatility is costly and that it ;er/anently affects invest/ent+ 1hey find a strong negative association 9et6een cash flo6 volatility and average levels of invest/ent in ca;ital ex;enditures, ,KD and advertising and a ;ositive association 9et6een cash flo6 volatility and costs of accessing external ca;ital+ 1hese findings suggest that cash flo6 volatility increases 9oth the li:elihood as 6ell as the costs of accessing external ca;ital /ar:ets+ Our study contri9utes to this literature 9y directly testing the hy;othesis that fir/s 6ith s/ooth financials are valued at a ;re/iu/ relative to fir/s 6ith volatile financials 6hile controlling for other deter/inants of fir/ value, such as siDe, leverage, ;rofita9ility, and gro6th, as 6ell as alternative ty;es of ris:, such as syste/atic and idiosyncratic+ S;ecifically, if cash flo6 volatility is costly as docu/ented 9y .inton and Schrand %1$$$(, then it should negatively affect fir/ value+ Our test of this hy;othesis extends the findings in Allayannis and 5eston %#!!1( 9y ex;laining 6hy hedging /ay have a ;ositive i/;act on fir/ value+ 1his is an i/;ortant result 9ecause it identifies the trans/ission /echanis/ through 6hich ris: /anage/ent can i/;act fir/ value, na/ely, 9y ;roducing a s/oother series of financial state/ents+ An addition, this result also co/;le/ents evidence 9y .inton and Schrand %1$$$( on the costs of cash flo6 volatility, as it docu/ents the negative i/;act of cash flo6 volatility on value+

5e also test the hy;othesis that earnings volatility negatively affects fir/ value+ @inancial ris: /anage/ent affects cash flo6 volatility, and in turn, earnings volatility+ 0o6ever, fir/s can also affect earnings volatility directly 9y engaging in earnings s/oothing via accrual esti/ates+ 1he literature has docu/ented a nu/9er of reasons fir/s /ay 6ant to re;ort s/ooth earnings+ @or instance, lo6 earnings volatility /ay increase analystsC follo6ing and i/;rove value %>ang et al+ %#!!#((, attract a larger nu/9er of institutional investors %Badrinath et al+ %1$4$((, andIor reduce the ;erceived 9orro6ing costs %1rue/an and 1it/an %1$44(, @rancis et al+ %#!!&((+ Several theoretical /odels have 9een develo;ed arguing that inco/e s/oothing relates to /anagers desire to signal their ;rivate infor/ation a9out future earnings to investors %<irschenheiter and .ela/ud, %#!!#(, San:ar and Su9ra/anya/ %#!!1(, De/s:i %1$$4(+ Given these argu/ents, if inco/e s/oothing via accruals is valued 9y investors then 6e ex;ect earnings volatility to 9e negatively related to fir/ value after accounting for cash flo6 volatility+ 1.2 Sample Description and ethodology

Our initial sa/;le includes all fir/s 6ith non)/issing o9servations for assets and sales for 6hich 6e find /atching data on ",SP and 9oth Fuarterly and annual "O.PUS1A1 data9ases 9et6een 1$4' and #!!#+ 0o6ever, the nature of our tests, 6hich reFuires esti/ation of earnings and cash flo6 volatility and syste/aticIunsyste/atic ris: i/;oses strong data reFuire/ents for inclusion in our final sa/;le+ An order to co/;ute /ar:et /odel 9etas and residuals, 6e select only fir/s 6ith at least '! non)/issing /onthly returns for a given five)year ;eriod %1$4')43, 1$44)$#, and 1$$')1$$3(+ @urther, to esti/ate the volatility of Fuarterly earnings 6e reFuire each

fir/ to have at least ten non)/issing Fuarterly o9servations for earnings ;er share during each five)year ;eriod+ Since our tests use five)year /easures that are 9oth for6ard and 9ac:6ard loo:ing, fir/s /ust have sufficient data in 9oth the ;revious five years, and in the follo6ing five years to 9e included in our sa/;le+ 1hus, 6e use only valid o9servations for 1$43, 1$$# and 1$$3 in our analysis+ 1he use of inde;endent sa/;le ;eriods to esti/ate earnings and cash flo6 volatilities ensures that our /easures of earnings and cash flo6 volatility %as 6ell as idiosyncratic and syste/atic ris:( are not suffering fro/ severe serial correlationE ho6ever, the dra69ac: is that such reFuire/ent reduces the nu/9er of o9servations used+ =ven so, the correlations 9et6een the earnings %cash flo6( volatilities esti/ated 9et6een the ;eriods are high %!+ 1 and !+3' res;ectively(, 6hich /a:es the use of overla;;ing data, an unattractive alternative+ 1he final sa/;le consists of a total of 6,$$3 fir/)year o9servations+ 5hile our sa/;le selection /ay 9e restrictive, our sa/;le is generally re;resentative of the "O.PUS1A1 ;o;ulation, though our fir/s are a little larger and hold less de9t+ ?evertheless, our inferences are not conta/inated 9y any selection 9ias induced 9y our screens since our tests are entirely restricted to 6ithin)sa/;le co/;arisons+ 1a9le 1 re;orts su//ary statistics of our /ain varia9les+ Panel A re;orts statistics on the sa/;le characteristics and Panel B re;orts statistics on our ris: /easures+ Our sa/;le fir/s have a /ean value of assets of L1,'$6 /illion %/edian of L1&'( and a /ean eFuity value of L1,#'$ /illion+ On average our sa/;leCs de9t)to)assets ratio is !+1$ %/edian of !+1&(+ 5e /easure gro6th a nu/9er of different 6ays 6ith the first one 9eing the co/;ound annual sales gro6th rate over the future five years+ .ean %/edian(

sales gro6th for our sa/;le fir/s 6as !+!4 %!+!6(+ Our other /easures of gro6th are the annual ratios of ca;ital ex;enditures %"AP2)to)Sales(, research and develo;/ent %,KD) to)Sales( and advertising %Advertising)to)Sales( all over conte/;oraneous sales+ @or the last t6o varia9les 6e eFuate /issing o9servations to ! in order to /aintain the sa/;le siDe+ 1he results are unaltered if 6e exclude these varia9les+ 5e use the /ar:et)to)9oo: ratio as an a;;roxi/ation of 1o9inCs Q, 6hich in turn is a ;roxy for fir/ value+3 Our sa/;le /ean /ar:et)to)9oo: ratio is 1+ 3 and the /edian is 1+1!+4 1hese values are si/ilar to values for Q docu/ented in earlier studies %see, e+g+, Allayannis and 5eston %#!!1((+ Our ;ri/ary /easure of cash flo6 is cash flo6 fro/ o;erations fro/ the state/ent of cash flo6s %"O.PUS1A1 Fuarterly data1!4( scaled 9y shares outstanding %Fuarterly data61( ad7usted for stoc: s;lits %Fuarterly data13(+ Use of this /easure li/its the sa/;le ;eriod to ;ost 1$43 9ecause the state/ent of cash flo6s 6as not reFuired for all ;u9licly traded fir/s until 1$44+ Although this so/e6hat restrictive, the ;ur;ose of our tests is to exa/ine the valuation of s/ooth financial state/ents therefore 6e vie6 it as necessary to utiliDe financial state/ent nu/9ers that are actually re;orted 9y the fir/ rather than the alternative of constructing cash flo6 nu/9ers utiliDing inco/e state/ents and changes in 9alance sheet ite/s+ @urther, 0ri9ar and "ollins %#!!#( illustrate that utiliDing inco/e state/ents and 9alance sheets to esti/ate accruals can severely 9ias esti/ates so/eti/es co/;letely altering statistical relations+ Given cash flo6s are also
3

1his /ethodology is co//on in the literature+ @or exa/;le, the /ethodology has 9een used in cross) listing %see Doidge, <arolyi, and StulD %#!!'((, cor;orate diversification %>ang and StulD %1$$&(, and Servaes %1$$6((, ta:eovers %Servaes %1$$1((, eFuity o6nershi; %>a Porta, >o;eD de Silanes, Shleifer, and Vishny %#!!#( and >ins %#!!'((, and ris: /anage/ent %Shin and StulD %#!!!(, and Allayannis and 5eston %#!!1((+ 4 Allayannis and 5eston %#!!1( sho6 that several /easures used to ;roxy for 1o9inCs J are highly correlated 6ith each other and also highly correlated 6ith the si/;le /ar:et)to)9oo: ratio used here+

calculated utiliDing changes in 9alance sheet ite/s, the 9ias docu/ented in 0ri9ar and "ollins %#!!#( also ;otentially extends to cash flo6s+ 5e address this issue in the ro9ustness section of the ;a;er+ Our /ain /easure of earnings is diluted earnings ;er share 9efore extraordinary ite/s %Fuarterly data$(, 9ut 6e have also used alternatively a( earnings ;er share fro/ o;erations %data133( 9( o;erating inco/e 9efore de;reciation %data #1( scaled 9y average total assets, as 6ell as c( 9asic earnings ;er share %9oth 6ith and 6ithout extraordinary ite/s(+ Our results are ro9ust to the use of these alternative earnings /easures+ As sho6n on 1a9le 1, Panel B, the /ean %/edian( Fuarterly earnings ;er share for our sa/;le fir/s is !+!6 %!+!$(, and the average %/edian( standard deviation of earnings ;er share is !+'3 %!+1$(+ At is i/;ortant to note exactly 6hich /easures of ris: should 9e related to fir/ value+ Of course, ;ast volatility should 9e ;riced into fir/ value at ti/e t8 1herefore, it is so/e6hat difficult to /a:e inferences regarding 1o9inCs Q and ;ast levels of earnings or cash flo6 volatility+ 5hat should /atter for fir/ value at ti/e t is the ex;ectation of future cash flo6s or earnings volatility+ Since ris: /easures do not follo6 a rando/ 6al: %see Shin and StulD %#!!!( for a discussion( 6e cannot assu/e that earningsIcash flo6 volatility at ti/e t eFuals earningsIcash flo6 volatility at ti/e t M 1+ As a result, 6e follo6 Shin and StulD %#!!!( in constructing a N;erfect foresightO /odel of earnings and cash flo6 volatility+ 5e use earnings or cash flo6 volatility in t M 1 as our /easure of the ti/e t ex;ected future volatility+ @or exa/;le, our /easure of earningsIcash flo6 volatility for fir/ i in 1$43 6ould 9e the standard deviation of Fuarterly earningsIcash flo6 in years 1$44)1$$#+ 1his /easure gives us a clean 6ay to test ho6 fir/ value

relates to ex;ected future volatility 9ased only on the no)ar9itrage assu/;tion that the /ar:et does not syste/atically under) or over)esti/ate financial state/ent volatility+$ Our /easures of cash flo6 and earnings volatility are constructed as the standard deviation of Fuarterly earnings ;er share and cash flo6 ;er share, res;ectively, over a five)year ;eriod+ 1! 1hat is, our /easure for earnings volatility for each fir/ in 1$43 is the standard deviation of Fuarterly earnings ;er share over the #! Fuarterly o9servations 9et6een 1$44 and 1$$#+ 5hile this /ethod /ay 9e crude, Section '+& ex;lores the sensitivity of our results to alternative /easures 9ased on alternative ti/e)series /odels and illustrates our results are ro9ust to a variety of different /easure/ent sche/es+ 1o co/;are 6ith earnings volatility, 6e use cash flo6 scaled 9y the nu/9er of shares, and alternatively cash flo6 scaled 9y assets, in our esti/ation of cash flo6 volatility+ 1hese t6o /easures are highly correlated and ;roduce si/ilar results+ @urther, our esti/ates of earningsIcash flo6 volatility are not Fualitatively changed 9y inclusionIexclusion of extraordinary ite/s+ 1he average Fuarterly cash flo6 ;er share of our sa/;le fir/s is !+'# and the /ean cash flo6 volatility is !+61+ 1he average cash flo6 volatility is large and reflects the significant left)s:e6ness ;resent in /any of our cash flo6, earnings, and volatility /easures+ As a result, 6e use log transfor/ations of these varia9les in our regression)9ased tests as 6ell as chec: the ro9ustness of our results to the i/;act of outliers in Section '+1+ 5e esti/ate 9oth syste/atic and fir/)s;ecific ris: using a one)factor /ar:et /odel 6ith returns on the ",SP value)6eighted index as a ;roxy for the /ar:et+ 5e
$

Given the high o9served autocorrelation of cash flo6 and earnings volatility, our results also do not change if 6e use Nconte/;oraneousO esti/ates of earnings or cash flo6 volatility instead of the N;erfect foresightO ones+ 1! @ollo6ing .inton and Schrand %1$$$( 6e also utiliDed the coefficient of variation as a /easure of earnings and cash flo6 volatility+ 1he results are unaltered+

1!

co/;ute syste/atic ris: for each fir/, i, as the ;roduct of the sFuare of its /ar:et ris: %P#( and the /ar:et volatility Q#/ + @or the 1$43 sa/;le, 6e use alternatively the Nconte/;oraneousO syste/atic ris: esti/ated during 1$4&)1$43, as 6ell as the N;erfect foresightO esti/ates during 1$44)1$$# %the sa/e /ethodologies 6ere utiliDed for the 1$$# and 1$$3 ;eriods(+ @ir/ s;ecific ris: is the difference 9et6een total ris: and syste/atic ris:, 6here 6e esti/ate total ris: as the standard deviation of /onthly returns over the five)year ;eriod+ Si/ilar to syste/atic ris:, 6e use alternatively the Nconte/;oraneousO as 6ell as the N;erfect foresightO esti/ates+ 1his has no significant i/;act on our results and therefore 6e re;ort results utiliDing the conte/;oraneous /easures+ Our sa/;leCs average syste/atic ris: is !+!#! and its average fir/)s;ecific ris: is !+1&!+ 1a9le # ;resents correlations of our /ain varia9les+ 5e note several interesting findings, although it is difficult to dra6 9road conclusions fro/ such univariate statistics+ "onsistent 6ith our hy;othesis, 9oth earnings and cash flo6 volatility are negatively correlated 6ith fir/ value %)!+#1 and )!+'3 res;ectively(+ @urther, 1o9inBs Q is ;ositively associated 6ith all of the gro6th /easures and negatively associated 6ith de9t)to)total assets+ @ir/ s;ecific ris: actually a;;ears to 9e ;ositively related to 1o9inBs Q, 9ut given the univariate nature of this analysis 6e are hesitant to /a:e conclusions fro/ any of the results+ 2. !ash flow volatility, earnings volatility, and firm value 2.1 "nivariate tests An this su9)section 6e ;resent univariate tests of the hy;othesis that earnings and cash flo6 volatility are inversely related to fir/ value+ 1a9le ', Panel A ;resents the

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results of these univariate tests+ @irst, 6e divide our sa/;le into Fuintiles according to earnings volatility %"olu/ns 1K#( or cash flo6 volatility %"olu/ns 'K&(+ 5e then co/;ute the average Q %colu/ns 1 K '( and the /edian Q %colu/ns # K &( for each Fuintile and co/;are Qs across the volatility Fuintiles+ "onsistent 6ith our hy;othesis, fir/s in the largest earnings volatility Fuintile have the lo6est average Q of any Fuintile %1+#1(, 6hile fir/s in the s/allest earnings volatility Fuintile have the highest average Q of 1+$4+ An fact, Q declines /onotonically across Fuintiles, that is, fir/s in the Fuintile 6ith the second highest earnings volatility have the second lo6est average Q %1+'$(, fir/s in the third Fuintile have the third lo6est value %1+ &( and so forth until the Fuintile 6ith the lo6est earnings volatility, 6hich has the highest average Q+ 5e o9tain si/ilar results using /edian Q instead of average Q %colu/n #(+ A si/ilar ;attern is o9served 6hen 6e classify fir/s into Fuintiles according to cash flo6 volatility %i+e+, a /onotonically declining average Q as cash flo6 volatility increases(, the ;attern is so/e6hat stronger as 6itnessed 9y the greater dis;ersion 9et6een the high and lo6 categories in the 9oth the /ean and /edian colu/ns+ 1his is the first indication that ;erha;s the cash flo6 effect is stronger than the earnings effect+ "learly, /any factors /ay affect Q in a si/ilar 6ay as earningsIcash flo6 volatility, so to infer that earningsIcash flo6 volatility is inversely related to value, 6e need to exclude the i/;act of other factors on Q+ 5hile 6e develo; /ultivariate tests of our hy;othesis 9elo6, 6e also ;erfor/ univariate tests 6ith ;ortfolios for/ed on conditional sorts+ @or exa/;le, 6e first classify fir/s according to siDe Fuintile and then, 6ithin each Fuintile, 6e sort again 9y earningsIcash flo6 volatility+ Given the greater infor/ation asy//etries that exist for s/all fir/s and the ;otential larger 9an:ru;tcy

1#

costs that s/all fir/s face %see 5arner %1$33((, 6e ex;ect that the negative relationshi; 9et6een volatility and value is stronger %/ore severe( a/ong s/all fir/s than a/ong large fir/s+ 1a9le ', Panels B, " and D ;resent the results of these conditional univariate tests utiliDing the earnings volatility /easure as a ;roxy for financial state/ent ris:+11 5ithin each siDe Fuintile, 6e find that the average Q decreases al/ost /onotonically as 6e /ove fro/ lo6 to high earnings volatility Fuintile+ @or exa/;le, 6ithin the largest siDe fir/s, the average Q goes do6n fro/ 1+41 for the fir/s 6ith the lo6est earnings volatility to !+$$ for the fir/s 6ith the highest earnings volatility 6ith the difference 9eing highly significant+ A si/ilar /onotonic decrease is o9served 6ithin /ost Fuintiles+ 1he decrease in value in a9solute /agnitude and ;ercentage ter/s occurs in the larger siDe Fuintiles, o;;osite fro/ 6hat 6e ex;ected+ 1a9le ', Panel " sho6s results of a si/ilar univariate test 6here 6e classify fir/s into Fuintiles according to their de9t)to)assets ratio and earnings volatility+ 5e ex;ect fir/s 6ith the highest de9t)to)assets ratio to 9e /ore affected 9y earnings volatility than fir/s 6ith the lo6est de9t)to)assets ratio, 9ecause fir/s 6ith high de9t)to)assets have ;resu/a9ly higher costs of accessing external ca;ital /ar:ets and face higher 9an:ru;tcy costs+ Sur;risingly, 6e find that it is 6ithin the s/allest de9t)to)assets Fuintile that 6e find the largest decline in value as 6e /ove fro/ lo6 to high earnings volatility+ S;ecifically, the average Q dro;s fro/ 1+'3 to 1+!4 %a dro; of !+#$ or #1+# ;ercent( 6ithin the largest de9t)to)eFuity Fuintile, 6hile it dro;s fro/ #+4! to 1+3! %a dro; of 1+1! or '$+' ;ercent( 6ithin the s/allest de9t)to)eFuity Fuintile+ A ;ossi9le ex;lanation is that these fir/s are associated 6ith /ost entrenched /anage/ent 6ho disli:e 9eing

11

1he results are si/ilar if 6e utiliDe cash flo6 volatility+

1'

/onitored %Berger, Ofe:, and Rer/ac: %1$$3(( or alternatively, that these are fir/s 6hich cannot ta:e on /ore de9t as their future ;ros;ects are sli/+ An addition to siDe and ca;ital structure, the level of earnings /ay also reflect the cost of accessing external ca;ital /ar:ets+ As a result, the relationshi; 9et6een earnings volatility and value /ay differ de;ending on the level of earnings+ 1a9le ', Panel D ;resents our results 9ased on earnings level conditional sorts+ "onsistent 6ith our ex;ectations 6e find that for fir/s 6ithin the s/allest Fuintile, there is a larger decline in value as 6e /ove fro/ the Fuintile 6ith the lo6est earnings volatility to the Fuintile 6ith the highest one %Q declines 9y #+& , fro/ '+3$ to 1+'& or 6&+3 ;ercent vs+ 1+'3 or '+4 ;ercent 6ithin the Fuintile 6ith the highest earnings level(+ 1he decline ho6ever is not /onotonic across earnings level Fuintiles+ @inally, Panel = re;orts results fro/ univariate tests in 6hich 6e classify fir/s 9ased on 9oth cash flo6 and earnings volatility+ 5ith the exce;tion of Fuintiles & and , 6here the decline is not unifor/ly /onotonic, 6e find that 6ithin each earnings volatility Fuintile, the average Q /onotonically declines as cash flo6 volatility increases+ "onversely, 6ithin each cash flo6 volatility Fuintile, the average Q either does not change significantly or it increases %see for exa/;le cash flo6 volatility Fuintile (+ 1he largest t6o cash flo6 volatility Fuintiles actually illustrate a significant increase in value as one /oves fro/ lo6 to high earnings volatility+ 1his is inconsistent 6ith a /ar:et ;reference for s/ooth earnings %controlling for the underlying cash flo6 volatility( and in fact suggests that earnings s/oothing actually destroys value in these t6o Fuintiles+ 1his is an intriguing result given the 9enefits associated 6ith earnings s/oothing 9ehavior docu/ented in ;rior studies %i+e+ lo6er cost of ca;ital, /ore analyst follo6ing, greater

1&

institutional investor o6nershi;, etc+(+ Given the see/ingly contradictory findings, 6e 6ill investigate this relation /ore fully 9elo6+ Overall, our univariate tests docu/ent a negative relationshi; 9et6een earnings and cash flo6 volatility and fir/ value, 6hich is /ore severe a/ong fir/s that are large in siDe, have lo6 de9t)to)assets ratio and lo6 earningsIcash flo6 level+ An the next section 6e ;erfor/ further /ultivariate tests, in 6hich 6e control for other factors that have 9een sho6n ;reviously to 9e related to value+ 2.2 ultivariate tests

2.2.1 Earnings and !ash flow volatility levels An this su9)section 6e ;resent further regression)9ased tests of the hy;othesis that cash flo6 and earnings volatility are negatively lin:ed to fir/ value+ Our /ultivariate tests control for other factors that theory suggests and ;rior e/;irical 6or: has sho6n to have a significant effect on fir/ value+ S;ecifically, follo6ing >ang and StulD %1$$&( and Allayannis and 5eston %#!!1(, 6e control for the follo6ing factors8 %1( siDe, 9y using the log of total assets as a ;roxyE %#( ;rofita9ility, 9y using ,OA as a ;roxyE %'( invest/ent gro6th and intangi9le assets, 9y using as ;roxies the ratio of ca;ital ex;enditures to sales, the ratio of ,KD to sales, and the ratio of advertising ex;enditures to sales, as 6ell as future sales gro6thE and %&( leverage, 9y using the ratio of long)ter/ de9t to total assets+ 5e also control for industry effects using #)digit SA" industry controls and ti/e)effects using year indicators %1$43 and 1$$#(+ Given the significant s:e6ness ;resent in /any of our varia9les, and to ease inter;retation of our results, 6e ;ut our data through t6o transfor/ations 9efore esti/ating our regression /odels+ @irst, 6e ta:e log transfor/s of our ris: /easures and

siDe to reduce the ;otential i/;act of outliers on our analysis+ Second, 6e standardiDe all of our varia9les 9y su9tracting the sa/;le /ean and dividing 9y the sa/;le standard deviation+ 1hus, all regression coefficients are ;resented in co/;ara9le units+ ?one of these transfor/ations have a Fualitative i/;act on our results and are ;erfor/ed only for ro9ustness and ease of inter;retation+ An 1a9le & 6e ;resent a series of regression results 6here our ris: /easures are added in seFuence to a standard set of confounding factors for 1o9inCs Q+ 1o ;rovide a 9asis for co/;arison, 1a9le &, "olu/n 1, ;resents the results of an O>S regression 6ith our log)scaled)transfor/ed Q as the de;endent varia9le and the varia9les descri9ed a9ove as inde;endent varia9les+ 1he results 6e o9tain are very si/ilar to 6hat theory ;redicts and are in line 6ith >ang and StulD %1$$&( and Allayannis and 5eston %#!!1(+ @or exa/;le, 6e find that siDe is negatively related to Q, suggesting that s/aller fir/s have higher values+ On the other hand, ;rofita9ility %as /easured 9y ,OA(, sales gro6th, and intangi9le assets %as /easured 9y ,KD and Advertising( are all ;ositively and significantly related to value, consistent 6ith ;rior findings and argu/ents 9y .yers %1$33( and S/ith and 5atts %1$$#(+ @inally, leverage is not associated 6ith value after controlling for these other factors+ ?ote also the relatively high ,# %!+#&( o9tained in the regression+ An 1a9le &, "olu/n # 6e add our /ar:et /easures of syste/atic and fir/)s;ecific ris: to the ex;lanatory varia9les used in colu/n 1+ 1his regression is si/ilar to the one in Shin and StulD %#!!!(+ 5e find a negative and significant association 9et6een syste/atic ris: and fir/ value and a negative and significant association 9et6een fir/)s;ecific ris: and fir/ value+ 1hese results are not ;erfectly consistent 6ith the "AP., 6hich

16

;ostulates a negative relationshi; 9et6een syste/atic ris: and value and an insignificant relationshi; 9et6een fir/)s;ecific ris: and value+ 0o6ever, the negative association 9et6een idiosyncratic ris: and fir/ value is consistent 6ith the findings in recent asset ;ricing literature 6hich finds that idiosyncratic ris: /atters %see e+g+, Green and ,ydFuist %1$$3(, .al:iel and 2u %#!!#(, and Goyal and Santa "lara %#!!'((+ Proceeding 6ith our regressions, 1a9le &, "olu/n ', adds earnings volatility as an alternative /easure of ris:+ Our hy;othesis is that earnings volatility adversely affects fir/ value, even after controlling for other /easures of ris: and factors that are related to value such as siDe, ;rofita9ility, gro6th, leverage, and industry affiliation+ "onsistent 6ith our hy;othesis, 6e find that earnings volatility is negative and significantly associated 6ith Q suggesting that earnings volatility decreases value, as it increases the li:elihood of negative earnings sur;rises and the ;erceived 9orro6ing costs, and /ay result in lo6er analystsC coverage and lo6er institutional investor follo6ing %see e+g+, 1rue/an and 1it/an %1$44(, Brennan and 0ughes %1$$1(, >ang et al+ %#!!'(, and Badrinath, et al+ %1$4$(, and @rancis et al+ %#!!&((+ 1his finding is also interesting 9ecause it docu/ents that the effect of earnings volatility is a9ove and 9eyond the effect of fir/) s;ecific ris:+ @urther, earnings volatility significantly i/;roves the ex;lanatory ;o6er of the regression+ S;ecifically, the ad7usted ,# increases 9y #+' ;ercentage ;oints 6hen 6e add earnings volatility to the /odel+ Our fourth regression %1a9le &, "olu/n &( ;erfor/s a si/ilar test using cash flo6 volatility instead of earnings volatility+ 5e find that cash flo6 volatility is also negatively and significantly related to fir/ value, consistent 6ith the ris: /anage/ent hy;othesis that cash flo6 volatility is costly+ 1he ,# i/;rove/ent in this regression is even /ore

13

su9stantial resulting in an increase of 4+# ;ercentage ;oints+ 1his is an indication that cash flo6 volatility /atters /ore than earnings volatility for valuation ;ur;oses+ @inally, regression includes all /easures of ris: together+ Our results for our

control varia9les and /ar:et ris: /easures re/ain unaltered+ @urther, the results for cash flo6 volatility re/ain unchanged even after the addition of earnings volatility+ 1he effect on value is Fuite strong 6ith the coefficient indicating a one standard deviation increase in cash flo6 volatility results in '6+4 ;ercent decrease in value+ 1his is consistent 6ith .inton and Schrand %1$$$( and illustrates the value to ;resenting s/ooth cash flo6s+ By including cash flo6 volatility in the regression, 6e have altered the inter;retation of the coefficient on earnings volatility+ As ;reviously discussed, earnings volatility can 9e reduced via cash flo6 /anage/ent or via the accrual esti/ates of /anagers+ 5hen 9oth cash flo6 and earnings volatility are included in the /odel, the coefficient on earnings volatility re;resents the value of s/oothing earnings via accrual /anage/ent+ 5ith this in /ind, the result for earnings volatility is drastically altered 6hen considered si/ultaneously 6ith cash flo6 volatility as 6itnessed 9y the fact that the coefficient s6itches fro/ negative and significant in regression ' to ;ositive and significant in regression + @urther, the ;resence of earnings volatility only /arginally i/;roves the ex;lanatory ;o6er of the /odel 6hen cash flo6 volatility is included 9y itself %!+# ;ercentage ;oint i/;rove/ent in ,# relative to regression &(, 6hereas cash flo6 volatility significantly enhances the ex;lanatory ;o6er relative to regression ', 6hich only includes earnings volatility+ 1he ;ositive and significant coefficient on earnings volatility is inconsistent 6ith earnings s/oothing 9ehavior adding value+ An fact, it suggests that earnings s/oothing via accrual /anage/ent actually reduces value+

14

An unre;orted analyses, 6e included t6o additional /easures of earnings s/oothing 9ehavior utiliDed 9y >euD et al+ %#!!'(8 1( the ratio of earnings volatility to cash flo6 volatility and #( the association 9et6een accruals and conte/;oraneous cash flo6s, as 6ell as the association 9et6een changes in accruals and cash flo6s+ 5e utiliDed five years of Fuarterly data to calculate 9oth /easures and reFuired that a fir/ have at least ten o9servations to 9e included in the sa/;le+ 1he lo6er the ratio of earnings to cash flo6 volatility the greater the earnings s/oothing related to accrual activity+ >i:e6ise the /ore negative the association 9et6een accruals and cash flo6s the greater the s/oothing+1# 1he results fro/ these tests again failed to illustrate that earnings s/oothing 6as valued 9y the /ar:et+ 1o control for ;otential ;eriod s;ecific effects, as 6ell as the lac: of inde;endence fro/ /ulti;le o9servations of the sa/e fir/, 6e esti/ate the full /odel %regression of 1a9le &( each ;eriod and re;ort the results in 1a9le + Our su9);eriods

6ere chosen to include o9servations fro/ a recessionary ;eriod %1$43(, a recovery %1$$#( and a 9oo/ %1$$3(+ At could 9e that volatility is ;articularly i/;ortant in one ;eriod and not as i/;ortant in others+ 1he results are generally consistent across the su9);eriods 6ith cash flo6 volatility al6ays 9eing negative and significant+1' 1his indicates that regardless of the econo/yBs ;erfor/ance lo6 cash flo6 volatility is seen as valua9le after controlling for ris: and gro6th o;;ortunities+ 1he results also illustrate that earnings volatility is generally not ;riced or if so %1$$#( the ;ricing is not consistent 6ith

1#

1he negative correlation indicates inco/e s/oothing since for a negative shortfall in cash flo6s there 6ould 9e a ;ositive accrual esti/ate offsetting the effect of the shortfall %or vice versa(+ 1' 1he results for fir/ s;ecific ris: and siDe vary over the ;eriods, 6ith fir/ s;ecific ris: and siDe actually 9eing ;ositively ;riced in 1$$3+ 0o6ever, results for earnings and cash flo6 volatility, our varia9les of interest, are unaltered if 6e exclude these varia9les fro/ the analysis+

1$

/ar:et ;artici;ants valuing earnings s/oothing that results fro/ /anagerial esti/ates of accruals+ Although 6e have 9een una9le to docu/ent earnings s/oothing 9ehavior adds value, it /ay 9e that s/oothing 9ehavior is only valua9le 6hen cash flo6 volatilities are relatively high+ 5ith high cash flo6 volatility, earnings s/oothing /ay signal to the /ar:et that /anage/ent 9elieves the uno9serva9le econo/ic inco/e is /ore sta9le than the cash flo6s 6ould have one 9elieve+ At is /ore difficult to /a:e this argu/ent if cash flo6 volatility is already lo6+ 1he current regressions hold cash flo6 volatility constant 6hen assessing the i/;ortance of earnings volatility, 9ut the coefficient /ay actually vary across differing levels of cash flo6 volatility+ An order to assess this, 6e se;arate sa/;le fir/s into cash flo6 volatility Fuintiles and re)esti/ate regression ' fro/ 1a9le & 9y cash flo6 volatility Fuintile including only earnings volatility+1& 1he results ;resented in 1a9le 6, Panel A again fail to detect any value to earnings s/oothing 9ehavior as 6itnessed 9y the lac: of significance on the coefficient for earnings volatility in any Fuintile+ As a final ro9ustness chec: on this result, 6e sorted fir/s on earnings volatility Fuintiles and then ;erfor/ed the sa/e regressions this ti/e including cash flo6 volatility instead of earnings volatility+ Af the /ar:et utiliDes earnings volatility instead of cash flo6 volatility to 7udge the ris: of econo/ic inco/e then here 6e 6ould ex;ect the coefficient on cash flo6 volatility to 9e insignificant %at least in the lo6er earnings volatility Fuintiles 6here s/oothing is /ore li:ely(+ 1he results ;resented in Panel B indicate this is not the case 6ith all Fuintiles exhi9iting a significantly negative coefficient on cash flo6 volatility+

1&

"ash flo6 volatility is i/;licitly controlled for 9y se;arating fir/s into cash flo6 volatility Fuintiles ;rior to esti/ating the regressions+ ,esults are unaltered if cash flo6 volatility is included in the regressions+

#!

Overall, our results are consistent 6ith the findings in .inton and Schrand %1$$$( and further illustrate that cash flo6 volatility is valued even after controlling for ris: and gro6th o;;ortunities+ @urther, the findings indicate that earnings s/oothing has no inherent value after controlling for cash flo6 volatility+ An all of our tests a9ove 6e have found a strong negative association 9et6een cash flo6 volatility and 1o9inCs Q+ 5e have i/;lied that it is the volatility that causes a reduction in value+ 0o6ever, it could 9e that high)Q fir/s have lo6 cash flo6 volatility, and not the other 6ay round as 6e have i/;lied+ Antuitively, one 6ould ex;ect that high) Q fir/s 6ould 9e associated 6ith high %not lo6( cash flo6 and earnings volatility, if high Q and high earnings and cash flo6 volatility are 9oth associated 6ith gro6th fir/s+ @urther, it is difficult to i/agine 6hy lo6 Q fir/s %those 6ith a relatively lo6er ;resent value of gro6th o;;ortunities( should, ceteris ;ari9us, have /ore volatile cash flo6s+ An fact, on the contrary, Ber:, Green, and ?ai: %1$$$( argue that the gro6th o;tions of a fir/ are an additional source of ;riced ris:+ Our finding that it is lo6 cash flo6 volatility that is associated 6ith high J gives /ore credence to our story suggesting that volatility is costly and that it negatively i/;acts value+ As a result, 6e thin: it is unli:ely that our results are syste/atically 9iased 9y endogeneity 9et6een cash flo6Iearnings volatility and value+ Another ;otential concern is that earningsIcash flo6 volatility /ay si/;ly ;ic: u; the i/;act of hedging on J, 6hich Allayannis and 5eston %#!!1( docu/ent+ 0edging 6ould reduce cash flo6 volatility and therefore lo6 cash flo6 volatility /ay 9e an indication that fir/s hedge, 6hich in turn leads to a higher value+ Our findings are 9roadly consistent 6ith this ex;lanation, ho6ever our results extend to other for/s of

#1

cash flo6 /anage/ent, including ti/ing of ;ay/entsIcollections and tax ;lanning a/ong others+ @urther, 6e ;rovide an incre/ental contri9ution to Allayanis and 5eston %#!!1( since 6e ;rovide evidence for the trans/ission /echanis/ 6here9y hedging can create value 9y ;roducing a s/oother ti/e)series of financial state/ents+ #. Ro$ustness 1his section ex;lores the ro9ustness of our results to a nu/9er of different regression s;ecifications and esti/ation /ethodologies+ 5e 9egin 6ith tests of the hy;othesis that earnings and cash flo6 volatility are negatively related to fir/ value 9ased on five)year change regressions %rather than levels(+ 5e also investigate the sensitivity of our results to a variety of s;ecifications and esti/ation techniFues, the role of financial distress, and our esti/ation of earningsIcash flo6 volatility+ All of these tests do not change the conclusions fro/ our tests ;resented in Section # and continue to su;;ort the hy;othesis that relatively s/ooth financial state/ents are valued at a ;re/iu/+ #.1 %lternative specifications and estimation techni&ues. Overall, 9oth our ;ooled and annual regression results are ro9ust+ Our results are al/ost identical regardless of the esti/ation techniFue or ;articular regression s;ecification that 6e use+ S;ecifically 6e find Fualitatively si/ilar results under the follo6ing s;ecifications8 a( @our different /easures of earnings8 earnings ;er share fro/ o;erations, earnings ;er share %diluted( fro/ o;erations, earnings ;er share %9asic( including extraordinary ite/s and earnings ;er share %9asic( excluding extraordinary ite/s+ 9( 1he inclusion of cash flo6 level and earnings ;er share as additional controls+ c( 1he inclusion of '), or &)digit SA" industry controls %instead of #)digit SA"s(+

##

d( 1he use of total ris: in lieu of syste/atic and idiosyncratic ris:+ e( Using the variance %instead of the standard deviation( of earnings and cash flo6+ f( Using either the N;erfect)foresightO /easures descri9ed in section 1+# or the conte/;oraneous value for either earnings or cash flo6 volatility+ g( Sensitivity to outliers8 5e find Fualitatively si/ilar results 9ased on a sa/;le 6here 6e 6insoriDe all of our varia9les at ten ;ercent+ h( 1he use of long run changes in 1o9inBs Q as the de;endent varia9le %i+e+ changes rather than levels(+ i( @ollo6ing .inton and Schrand %1$$$(, 6e also utiliDed coefficients of variation as /easures of earnings and cash flo6 volatilities+ 7( 1he use of Price)to)=arnings ratios as a /easure of fir/ value rather than 1o9inBs Q+ Given the strength of our results, our ro9ustness tests find su;;ort for the conclusions ;resented in Section # that financial state/ent s/oothness /atters, ceteris ;ari9us, to investors+ @urther, 6e are una9le to detect earnings s/oothing /atters after controlling for ris:, gro6th factors, and cash flo6 volatility+ Our results are ho6ever sensitive to the esti/ation of cash flo6s utiliDing inco/e state/ent and 9alance sheet infor/ation rather than the re;orted cash flo6s fro/ the financial state/ents+ @or instance, if 6e ado;t the /ethodology in .inton and Schrand %1$$$( to calculate cash flo6s %i+e+ Sales less cost of goods sold less selling, general and ad/inistrative ex;enses, less the change in 6or:ing ca;ital(, then the coefficient on earnings volatility is negative and significant, incre/entally to the negative and significant coefficient on cash flo6s+ An fact, the effect of earnings volatility is larger than the effect of cash flo6 volatility suggesting earnings s/oothing via accruals is valued /ore than s/oothing via cash flo6 /anage/ent+ Although Barth et al+ %#!!1( illustrates that current earnings are 9etter ;redictors of future cash flo6s than current cash flo6s our use of future realiDed volatilities reduces the a;;arent infor/ation advantage in

#'

earnings for future cash flo6s+1 1herefore, given our research design, 6e find it i/;lausi9le for earnings volatility to have a greater effect on value than cash flo6 volatility leading us to conclude the calculation of cash flo6s utiliDing inco/e state/ent and 9alance sheet accounts is /easured 6ith considera9le error for our sa/;le of fir/s+ 1his is consistent 6ith the findings in 0ri9ar and "ollins %#!!#( and hel;s to illustrate that their findings are not only i/;ortant for accrual esti/ation, 9ut they are also i/;ortant for analyses using cash flo6s+ #.2 'inancial Distress At could si/;ly 9e the case that our /easures of earnings and cash flo6 volatility serve as a ;roxy for fir/s facing financial distress+ Since there is nothing novel a9out the finding that fir/s in financial distress have lo6er value, 6e /ust 9e sure that our results hold even for fir/s that are in relatively good financial health+ 1o test 6hether our results are driven 9y a su9)sa/;le of fir/s that are in %or near( financial distress, 6e test our hy;othesis 9ased on a su9)sa/;le of fir/s excluding fir/s that /eet any of the follo6ing selection criteria8 a( ?egative average Fuarterly earnings over the five)year ;eriod+ 9( ?egative average Fuarterly cash flo6s over the five)year ;eriod+ c( Average total assets in the lo6est sa/;le Fuintile+ d( O9servations in the highest leverage Fuintile+ e( O9servations in the lo6est leverage Fuintile+ 1hese filters ensure that our tests are ;erfor/ed only on larger, ;rofita9le co/;anies 6ith a /oderate ca;ital structure and ;ositive cash flo6s fro/ o;erationsE

0o6ever, as ;reviously /entioned, our results are ro9ust to utiliDing conte/;oraneous /easures of volatility+

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these are fir/s that are unli:ely to 9e in financial distress+ Such filters eli/inate over 6! ;ercent of our o9servations to a final sa/;le of #, &4 fir/ years+ ?evertheless, 6e continue to find that cash flo6 volatility has a negative effect on fir/ value and earnings s/oothing is not valued+ 1hese results are, again, 9oth statistically and econo/ically significant+ #.# Estimation of cash flow(earnings volatility. An our ;revious tests, 6e esti/ate 9oth cash flo6 and earnings volatility 9y si/;ly co/;uting the ti/e)series standard deviation of a fir/Cs Fuarterly earnings over a five) year ;eriod+ 1his /easure is so/e6hat crude and could 9e 9iased if earnings or cash flo6s are non)stationary %i+e+, exhi9it ;ersistence, trend, or seasonality(+ An this su9) section 6e ex;lore the sensitivity of our results to our esti/ation of the volatility+ Our general a;;roach is to esti/ate a ti/e)series /odel for earnings and cash flo6s and co/;ute the ti/e)series volatility only for the stationary co/;onent of the data+ 1here is a vast literature in accounting %see e+g+, Bro6n %1$$'( and references therein( suggesting that generally, earnings are strongly ;ersistent and exhi9it seasonality+ 1o account for such ti/e)series ;ro;erties, 6e esti/ate a /odel of earnings %cash flo6s( that accounts for this ;ersistence 6ith lagged values of earnings %cash flo6s(, as 6ell as Fuarterly du//y varia9les+ Our esti/ation eFuation for each fir/ is8
E t = + 1 E t 1 + q I Quarter + t
q =# &

%1(

An this regression the constant ter/, S, along 6ith the A,%1( coefficient 1 ca;tures serial correlation and any ti/e)series trend in earnings+ 5e esti/ate the a9ove /odel for each fir/ se;arately 9ased on our full sa/;le of fifteen years of Fuarterly

earnings data %1$44)#!!#(+ Using the results fro/ this regression for each fir/, 6e co/;ute the five)year sa/;le standard deviation of the esti/ated residuals8 Volatility of earnings T Stdev% t ( 5e use a si/ilar /odel to esti/ate cash flo6 volatility+ An addition to the si/;le ti/e)series /odel descri9ed a9ove, 6e also co/;uted residuals using alternative ti/e) series /odels that include additional lags of earnings or cash flo6s as 6ell as a /ean reversion %Et)&( ter/+ Using the residuals fro/ any of these alternative ti/e)series /odels to co/;ute earnings or cash flo6 volatility does not Fualitatively alter any of our results+ As in Section #, and consistent 6ith the alternative s;ecifications descri9ed a9ove, 6e find that all /easures of cash flo6Iearnings volatility continue to /easure the sa/e ;heno/ena+ Using any of the various /easures of financial state/ent volatility, 6e continue to find that cash flo6 volatility is negatively valued and earnings s/oothing is not valued 9y investors+ ). !onclusions 1his ;a;er tests the hy;othesis that earnings and cash flo6 volatility have a negative effect on fir/ value+ 5hile ;rior 6or: suggests that cash flo6 volatility is costly, that it ;er/anently affects invest/ent, and that ris: /anage/ent adds value, no ;rior 6or: has investigated directly such a relation 9et6een value and the s/oothness of financial state/ents+ 1his is i/;ortant as it ;rovides a 7ustification for the 6ides;read ris: /anage/ent activities that fir/s engage in+16 An general, 6e find that cash flo6 volatility is significantly and negatively associated 6ith fir/ value, 6hile earnings volatility is either not valued or ;ositively
16

Allayannis and 5eston %#!!1( re;ort that a;;roxi/ately 6&H of their sa/;le fir/s 6ith ex;osure to exchange rate ris: use currency derivatives to hedge their ex;osures+

#6

valued after controlling for cash flo6 volatility+ 1hese findings illustrate the i/;ortance of ris: /anage/ent activities ai/ed at reducing future cash flo6 volatility+ @urther/ore, our results indicate that earnings s/oothing acco/;lished through accrual esti/ates does not a;;ear to 9e valued 9y the /ar:et+ 1his is an i/;ortant distinction fro/ the ;rior literature and suggests that /anagers focus their activities on ;roducing s/ooth cash flo6s rather than concerning the/selves necessarily 6ith re;orting s/ooth earnings via accrual esti/ates+ An general, our ;a;er contri9utes to the 9roader ris: /anage/ent literature 9y docu/enting that financial state/ent volatility is costly and that it directly affects value+ Our results are consistent 6ith ris: /anage/ent theory and suggest that /anagersC efforts to ;roduce s/ooth financial state/ents add value to the fir/+

#3

References
Allayannis, G+, and 5eston -+, #!!1, 1he Use of @oreign "urrency Derivatives and @ir/ .ar:et Value, The Review of Financial Studies, 1&, #&')#36+ Badrinath, S+G+, Gay, G+D+, and <ale, -+D+, 1$4$, Patterns of Anstitutional Anvest/ent, Prudence and the U.anagerial Safety ?etU 0y;othesis, Journal of Risk and Insurance 6, 6! )6#$+ Barton, -+, #!!1, Does the use of @inancial Derivatives Affect =arnings .anage/ent DecisionsV The Accounting Review, 36, 1)#6+ Barth, .+, "ra/, D+, and ?elson, <+, #!!1, Accruals and the ;rediction of future cash flo6s, The Accounting Review, 36, #3) 4+ Barth, .+, <asDni:, ,+, and .c?ichols, .+, 1$$4, Analyst "overage and Antangi9le Assets, Journal of Accounting Research '$, 1)'&+ Berger, P+, Ofe:, =+, and Rer/ac:, D+, 1$$3, .anagerial =ntrench/ent and "a;ital Structure Decisions, Journal of Finance #, 1&11)1&'4+ Ber:, -+, Green, ,+, and ?ai:, V+, 1$$$, O;ti/al Anvest/ent, Gro6th O;;ortunity, and Security ,eturns, Journal of Finance &, 1 ')16!3+ Brennan, .+, and 0ughes, P+, 1$$1, Stoc: Prices and the Su;;ly of Anfor/ation, Journal of Finance &6, 166 )16$1+ Bro6n, G+, #!!1, .anaging @oreign =xchange ,is: 6ith Derivatives, Journal of Financial Economics, 6!, &!1)&&4+ Bro6n, >+D+, 1$$', =arnings @orecasting ,esearch8 its A/;lications for "a;ital .ar:ets ,esearch, International Journal of Forecasting $, #$ )'#!+ "ollins, D+, ,oDeff, .+, and Dhali6al, D+, 1$41, 1he =cono/ic Deter/inants of the .ar:et ,e) action to Pro;osed .andatory Accounting "hanges in the Oil and Gas Andustry, Journal of Accounting and Economics ', '3)31+ De.arDo, P+, and Duffe, D+, 1$$ , "or;orate incentives for hedging and hedge accounting, The Review of Financial Studies 4+ De/s:i, -+S+, 1$$4, Perfor/ance /easure /ani;ulation, Contem orar! Accounting Research, 1 , #61)#4 + Doidge, "+, <arolyi, G+A+, and StulD, ,+, #!!#, 5hy are foreign fir/s listed in the U+S+ 6orth /oreV forthco/ing, Journal of Financial Economics+

#4

@aDDari, S+, 0u99ard, G+, and Petersen, B+, 1$44, @inancing constraints and cor;orate invest/ent, "rookings #a ers in Economic Activit!, 1&1)1$ + @rancis, -+, >a@ond, ,+, Olsson, P+.+, and Schi;;er, <+, #!!&, "osts of =Fuity and =arnings Attri9utes, The Accounting Review 3$ ?o+ &, $63)1!1!+ @root, <+, Scharfstein, D+, and Stein, -+, 1$$', ,is: /anage/ent8 "oordinating cor;orate invest/ent and financing ;olicies, Journal of Finance, &4, 16#&)16 4+ GecDy, "+, .inton, B+, and Schrand, "+, 1$$3, 5hy fir/s use currency derivativesV Journal of Finance, #, 1'#&)1' &+ Goel, A+.+, and 1ha:or, A+V+, #!!', 5hy do fir/s s/ooth earningsV Journal of "usiness36, 1 1)1$#+ Goyal, A+, and Santa)"lara, P+, #!!', Adiosyncratic ,is: .atters, Journal of Finance 4, $3 )1!!3+ Green, ,+"+, and ,ydFuist, <+, 1$$3, 1he Valuation of ?onsyste/atic ,is:s and the Pricing of S6edish >ottery Bonds, Review of Financial Studies 1!, &&3)&4!+ Graha/, -+, and ,ogers, D+, #!!#, Do @ir/s 0edge in ,es;onse to 1ax AncentivesV Journal of Finance 3, ;;+ 41 )4'$+ 0aushalter, D+, #!!!, @inancing Policy, Basis ,is:, and "or;orate 0edging8 =vidence fro/ Oil and Gas Producers, Journal of Finance , ;;+ 1!3)1 #+ 0unt, A+, .oyer, S+, and Shevlin, 1+, #!!!, =arnings volatility, earnings /anage/ent and eFuity value, University of 5ashington 5or:ing ;a;er+ 0aus/an, -+, and 1aylor, 5+, 1$41, Panel Data and Uno9serva9le Andividual =ffects, Econometrica, &$, 1'33)1'$4+ <a;lan, S+, and Gingales, >+, 1$$3, Do invest/ent)cash flo6 sensitivities ;rovide useful /easures of financing constraintsV, Quarterl! Journal of Economics, 16$)#1 + <irschenheiter, .+, and .ela/ud, ?+, #!!#, =arnings Fuality and s/oothing, Journal of Accounting Research &!, 361)3$6+ >a/ont, O+, 1$$3, "ash @lo6 and Anvest/ent8 Anternal "a;ital .ar:ets =vidence, Journal of Finance, 4')1!$+ >ang, >+, and StulD, ,+, 1$$&, 1o9inCs J, cor;orate diversification and fir/ ;erfor/ance, Journal of #olitical Econom!, 1!#, 1#&4)1#4!+

#$

>ang, .+, >ins, <+, and .iller, D+, #!!', AD,s, Analysts, and Accuracy8 Does "ross >isting in the US A/;rove a @ir/Cs Anfor/ation =nviron/ent and Ancrease .ar:et ValueV forthco/ing Journal of Accounting Research >a Porta, ,+, >o;eD)de)Silanes, @+, Shleifer, A+, and Vishny, ,+5+, Anvestor Protection and "or;orate valuation, #!!#, Journal of Finance 4, 11&3)113!+ >eland, 0+, 1$$4, Agency "osts, ,is: .anage/ent, and "a;ital Structure, Journal of Finance ', 1#1')1#&'+ >essard, D+, 1$$!, Glo9al "o/;etition and "or;orate @inance in the 1$$!s, Journal of A lied Cor orate Finance ', $)3#+ >euD, "+, ?anda, D+, and 5ysoc:i, P+D+, #!!', =arnings /anage/ent and investor ;rotection8 an international co/;arison, Journal of Financial Economics 6$, ! ) #3+ >ins, <+, #!!', =Fuity O6nershi; and @ir/ Value in =/erging .ar:ets, forthco/ing, Journal of Financial and Quantitative Anal!sis$ >ys, 1+, 1$4&, .andated Accounting "hanges and De9t "ovenants8 1he "ase of Oil and Gas Accounting, Journal of Accounting and Economics 6, '$)6 + .al:iel, B+, and 2u, R+, #!!#, Adiosyncratic ,is: and Security ,eturns, University of 1exas at Dallas 5or:ing Pa;er+ .erton, ,+"+, 1$43, A si/;le /odel of ca;ital /ar:et eFuili9riu/ 6ith inco/;lete infor/ation, Journal of Finance &#, &4') 1!+ .ian, S+, 1$$6, =vidence on cor;orate hedging ;olicy, Journal of Financial and Quantitative Anal!sis '1, &1$)&'$+ .inton, B+, and Schrand, "+, 1$$$, 1he A/;act of "ash @lo6 Volatility on Discretionary Anvest/ent and the "osts of De9t and =Fuity @inancing, Journal of Financial Economics &, &#')&6!+ .inton, B+, Schrand, "+, and 5alther, B+, #!!#, 1he role of volatility in forecasting, Review of Accounting Studies 3, 1$ )#1 + ?ance, D+, S/ith, "+, and S/ithson, "+, 1$$', On the deter/inants of cor;orate hedging, Journal of Finance, &4, #63)#4&+ San:ar, .+, and Su9ra/anya/, <+,+, #!!1, ,e;orting discretion and ;rivate infor/ation co//unication through earnings, Journal of Accounting Research '$, '6 )'46+

'!

Schi;;er, <+, 1$$1, "o//entary on AnalystsC @orecasts, Accounting %ori&ons , ;;+ 1! )1#1+ Servaes, 0+, 1$$1, 1o9inCs J and the Gains fro/ 1a:eovers, Journal of Finance &6, &!$) &1$+ Servaes, 0+, 1$$6, 1he Value of Diversification during the "onglo/erate .erger 5ave, Journal of Finance 1, 1#!1)1## + Sha;iro, A+, and 1it/an, S+, 1$46, An Antegrated A;;roach to "or;orate ,is: .anage/ent, in Stern, -+, "he6, D+%=ds+(, 1he ,evolution in "or;orate @inance, Basil Blac:6ell, ?e6 Ror:, ;;+''1)' &+ Shin, 0+, and StulD, ,+, #!!!, @ir/ Value and Gro6th O;;ortunities, Ohio State 5or:ing Pa;er+ S/ith, "+, and StulD, ,+, 1$4 , 1he deter/inants of fir/sC hedging ;olicies, Journal of Financial and Quantitative Anal!sis #!, '$1)&! + S/ith, "+, and 5atts, ,+, 1$$#, 1he Anvest/ent O;;ortunity Set and "or;orate @inancing, Dividend, and "o/;ensation Policies, Journal of Financial Economics, '#, #6')#$#+ StulD, ,+, 1$4&, O;ti/al hedging ;olicies, Journal of Financial and Quantitative Anal!sis 1$, 1#3)1&!+ StulD, ,+, 1$$!, .anagerial Discretion and O;ti/al @inancing Policies, Journal of Financial Economics, #6, ')#3+ 1ho/as, -+<+, and Ghang, 0+, #!!#, Value)relevant ;ro;erties of s/oothed earnings, "olu/9ia University 5or:ing Pa;er+ 1rue/an, B+, and 1it/an, S+, 1$44, An ex;lanation of accounting inco/e s/oothing, Journal of Accounting Research #6, su;;l8 S1#3)S1'$+ 1uc:er, 2+-+, and Garo6in, P+, #!! , Does inco/e s/oothing i/;rove earnings infor/ativenessV forthco/ing The Accounting Review+ 1ufano, P+, 1$$6, 5ho /anages ris:V An e/;irical exa/ination of ris: /anage/ent ;ractices in the gold /ining industry, Journal of Finance 1, 1!$3)11'3+ 5arner, -+, 1$33, Ban:ru;tcy costs8 So/e evidence, Journal of Finance '#, ''3)'&3+ Genner, .+, #!!1, 0o6 ris: /anage/ent creates shareholder value, @inancial Strategy Grou;, Salo/on S/ith Barney+

'1

%ppendi* 1
Advertising E' enditures () ) *8 1his ite/ re;resents the cost of advertising /edia %radio, television, ne6s;a;ers, ;eriodicals( and ;ro/otional ex;ense+ "o/;ustat data ite/ & + "eta8 "o/;uted fro/ the /ar:et /odel 9ased on five years of /onthly returns against the ",SP value)6eighted index+ @or exa/;le, the 9eta for a fir/ for the 1$$! o9servation is 9ased on the /onthly returns 9et6een 1$46 and 1$$!+ An the regressions, 6e use alternatively conte/;oraneous and ;erfect foresight 9etas follo6ing Shin and StulD %#!!!(+ Ca ital E' enditures () ) *8 1his ite/ re;resents ca;ital ex;enditures restated u; to 1! years for acFuisitions, accounting changes, andIor discontinued o;erations+ ,estated data is collected fro/ su//ary ;resentations and is re;orted 9y the co/;any+ Cash Flow volatilit!+ Standard deviation of o;erating cash flo6s %"o/;ustat Fuarterly data ite/ 1!4(+ Also use alternatively the standard deviation of the residuals fro/ various ti/e)series /odels descri9ed in text+ @inally, 6e also utiliDed the coefficient of variation as in .inton and Schrand %1$$$(+ Earnings volatilit!,alternative measures+ Standard deviation of earnings %using earnings /easure 1(+ Also use alternatively the standard deviation of the residuals fro/ various ti/e)series /odels descri9ed in text, #( further utiliDed the coefficient of variation of o;erating earnings as in .inton et al+ %#!!#(+ =arnings /easure 1 is constructed using "o/;ustat Fuarterly data$ 6hich is C=PS %Diluted( =xcluding =A+B 5e also use earnings /easure #, 6hich is constructed using "o/;ustat Fuarterly data133 6hich is C=arnings ;er share fro/ o;erations+C =arnings /easure ' is constructed using "o/;ustat Fuarterly data3 6hich is C=arnings ;er share %diluted( including extraordinary ite/s+C =arnings /easure & is constructed using "o/;ustat Fuarterly data11 6hich is C=arnings ;er share %9asic( including extraordinary ite/s+C =arnings /easure is constructed using "o/;ustat Fuarterly data1$ 6hich is C=arnings ;er share %9asic( excluding extraordinary ite/s+C Firm,s ecific risk8 "o/;uted as the residual ris: fro/ the /ar:et /odel as in Shin and StulD %#!!!(+ 1hat is, 6e ta:e total ris: and su9tract 9eta sFuared ti/es the variance of the /ar:et return %or total ris: /inus syste/atic ris:(+ -ong,term de.t () ) *8 "o/;ustat annual data ite/ $+ 1his ite/ re;resents de9t o9ligations due /ore than one year fro/ the co/;anyCs Balance Sheet date or due after the current o;erating cycle+ )arket risk+ Standard deviation of the ",SP value 6eighted /ar:et return 9ased on five years of /onthly returns over the ;revious five years of the o9servation unit+ 1hat is, the 1$43 value for /ar:et reflects the 1$4' to 1$43 ;eriod+ 0o6ever, in

'#

our statistical tests, 6e use alternatively the conte/;oraneous as 6ell as the ;erfect foresight forecast as esti/ators of the /ar:et return+ /um.er of common shares outstanding+ .easured at the end of the calendar year in /illions+ "o/;ustat data ite/ # + 1his ite/ re;resents the net nu/9er of all co//on shares outstanding at year)end+ 0 erating cash flows+ "o/;ustat Fuarterly data1!4, WO;erating Activities ?et "ash @lo6+B 5e co/;ute this /easure each Fuarter for each fir/ and ta:e the eFually) 6eighted ti/e)series average over all Fuarters during each five year ;eriod+ Research 1 2evelo ment E' enses ())*+ 1his ite/ re;resents s;ending on research and develo;/ent ex;enses as re;orted 9y the fir/+ "o/;ustat annual data ite/ &6+ Sales 3rowth+ 1he co/;ound annual gro6th rate of annual sales %"o/;ustat data ite/ 1#( over a five year ;eriod, 6here 6e utiliDe 9oth the ;erfect foresight /easure as 6ell as the conte/;oraneous version+ Share #rice+ .easured at the close of the fiscal year+ "o/;ustat data ite/ 1$$+ S!stematic risk+ "onstructed as 9eta sFuared /ulti;lied 9y the variance of the /ar:et return+ 1his /easure follo6s the sa/e construction as for the other /ar:et ris: /easures+ To.in4s Q+ UtiliDe the /ar:et)to 9oo: ratio as a ;roxy+ "onstructed as the ratio of the /ar:et value of eFuity and 9oo: value of long)ter/ de9t all divided 9y total assets+ 1he /ar:et value of eFuity is constructed 9y /ulti;lying the share ;rice ti/es the nu/9er of co//on shares outstanding+ Total Assets+ "o/;ustat annual data ite/ 6+ 1his ite/ re;resents current assets ;lus ;ro;erty, ;lant, and eFui;/ent, ;lus other non)current assets %including intangi9le assets, deferred charges, and invest/ents and advances(+ Total risk+ "onstructed as the standard deviation of /onthly returns over the five year ;eriod+ Again, the 1$43 /easure for total ris: is si/;ly the standard deviation of /onthly returns over the ;revious five years+ An the regressions, 6e use either conte/;oraneous /easures or the C;erfect foresightC /easures as in Shin and StulD %#!!!(+

''

+a$le 1 Summary Statistics 1his ta9le ;resents descri;tive statistics for our sa/;le of fir/s+ 1he sa/;le contains all "O.PUS1A1 fir/s 6ith availa9le annual and Fuarterly data and /atching data on ",SP during 1$43, 1$$# and 1$$3+ 1he final sa/;le consists of #,13 fir/s in 1$43, #, 3 fir/s in 1$$# and #,#&3 fir/s in 1$$3 for a total of 6,$$3 o9servations+ All varia9les are defined in A;;endix 1+

Panel A8 Descri;tive Varia9les Varia9le .ean 1otal Assets %.L( 1,'$6 =Fuity .ar:et Value %.L( ,eturn on Assets De9t)to)assets Sales gro6th "AP2)to)Sales ,KD)to)Sales Advertising)to)Sales 1o9inCs J Panel B8 .easures of ,is: Syste/atic ris: @ir/)s;ecific ris: =arnings ;er share %=PS( Volatility of =PS %std+ dev+( "ash flo6 ;er share %"@PS( Volatility of "@PS %std+ dev+( 1otal earnings 1otal cash flo6 1,#'$ !+!!& !+14 !+!4# !+1'& !+!6' !+!1# 1+ 6

Std+ &,#6 ', '! !+164 !+146 !+14& !+'&# !+#6! !+!#$ 1+& 1

# H '6 #4 )!+!! !+!14 !+!!# !+!#1 !+!!! !+!!! !+3&!

.edian 1& 1#6 !+!'$ !+1'4 !+!6' !+!&& !+!!! !+!!! 1+!$

3 H 3!6 3!! !+!3$ !+#$# !+1&3 !+!$# !+!#& !+!1# 1+3$

!+!#! !+1&! !+!6& !+'3' !+'## !+61# #1+3#6 '4+31!

!+!#' !+!6' !+'63 !+ #& !+&3& !+3!# 6$+3& 11$+1$ 6

!+!! !+!$# )!+!&3 !+!$! !+!'4 !+14& )!+!6! !+#'6

!+!1# !+1#4 !+!46 !+14$ !+#!4 !+'6' 1+ 16 #+$#

!+!# !+13$ !+#'& !+&1' !+&4 !+3'3 11+ 3 #!+&6

'&

+a$le 2 !orrelation +a$le 1his ta9le ;resents correlations a/ong our /ain ris: varia9les utiliDed in su9seFuent tests as 6ell as our ;roxy for fir/ value, 1o9inBs J+ All varia9les are defined in A;;endix 1+ P)values are re;orted in ;arentheses+ 1o9inCs J !+!1! %!+&!6( !+1!! %!+!!!( !+!! %!+6 $( )!+1#& %!+!!!( )!+#! %!+!!!( )!+'66 %!+!!!( !+!31 %!+!!!( !+!&6 %!+!!!( Syst+ ,is: 1 !+'4! %!+!!!( )!+#'4 %!+!!!( )!+#!1 %!+!!!( !+!'1 %!+!!1( )!+!$# %!+!!!( )!+116 %!+!!!( )!+114 %!+!!!( @ir/ ,is: =PS "@PS St+ dev+ St+ dev+ 1otal 1otal cash =PS "@PS earnings flo6

Syste/atic ,is: @ir/ S;ecific ,is: =arnings %=PS( "ash flo6 %"@PS( Volatility of =PS Volatility of "@PS 1otal earnings 1otal cash flo6

1 )!+&46 %!+!!!( )!+'34 %!+!!!( !+1& %!+!!!( )!+1'6 %!+!!!( )!+#$ %!+!!!( )!+#3# %!+!!!( 1 !+&3$ %!+!!!( )!+#$3 %!+!!!( !+! 3 %!+!!!( !+#$' %!+!!!( !+#&4 %!+!!!( 1 !+#'3 %!+!!!( !+'$1 %!+!!!( !+#43 %!+!!!( !+'41 %!+!!!( 1 !+6&3 %!+!!!( )!+!1# %!+''3( !+!&& %!+!!!( 1 !+!&$ %!+!!!( !+!3' %!+!!!( 1 !+$#4 %!+!!!( 1

'

+a$le # "nivariate Results 1his ta9le ;resents univariate results+ 5e grou; fir/s into Fuintiles 9ased on their earnings and cash flo6 volatility+ Panel A re;orts /ean and /edian 1o9inBs Q for earnings and cash flo6 volatility Fuintiles arranged fro/ lo6 to high+ 1he difference in /ean and /edian J 9et6een the lo6 and high Fuintiles is re;orted at the 9otto/ of the ;anel along 6ith the associated ;) values in ;arentheses+ Panels B)D ;resent further univariate results 6here, in addition to earnings volatility 6e also sort fir/s on siDe, leverage and total earnings levels+ Panel = ;resents results sorting on 9oth earnings and cash flo6 volatility Fuintiles+ Panel A8 Average 1o9inCs J =arnings Volatility .ean .edian >o6 # ' & 0igh Difference %>o6)0igh( P)value 1+$36 1+3!$ 1+ &# 1+'44 1+#!3 !+36$ %!+!!( 1+''' 1+#'$ 1+1!6 1+!#6 !+$!$ !+&#& %!+!!( "ash @lo6 Volatility .ean .edian #+'&3 1+36' 1+ #6 1+##1 !+$66 1+'41 %!+!!( 1+ 6& 1+'#3 1+1$# !+$3$ !+4!& !+3 $ %!+!!(

Panel B8 Average 1o9inCs J S/allest #+1$# 1+$#' 1+4#$ 1+3&6 #+! 4 !+1'& %!+&&( # 1+4! 1+ 4& 1+ ' 1+'#4 1+1 & !+6 1 %!+!!( SiDe Juintile ' & 1+4&1 1+$& 1+6$# 1+6$1 1+&16 1+&63 1+& 1 1+'63 1+#!& 1+1!1 !+6'3 %!+!! ( !+4&& %!+!!( >argest 1+4! 1+6!# 1+ !$ 1+##1 !+$43 !+414 %!+!!(

>o6 =arnings Volatility # ' & 0igh =arnings Volatility Difference %>o6)0igh( P)value

'6

+a$le # ,!ontinued"nivariate Results Panel "8 Average 1o9inCs J S/allest >o6 =arnings Volatility # ' & 0igh =arnings Volatility Difference %>o6)0igh( P)value #+3$$ #+'#' #+!4' 1+$!# 1+3!! 1+1!! %!+!!( De9t to 1otal Assets Juintile # ' & 1+$'1 1+33# 1+41' 1+&'4 1+'41 !+ ! 1+3! 1+ 1' 1+' ! 1+#43 1+!31 !+6'& %!+!! ( 1+614 1+'6$ 1+146 1+1 1+! 3 !+ 61 %!+!!( >argest 1+'3# 1+&1# 1+'13 1+#'4 1+!4# !+#$1 %!+!!(

%!+!!(

Panel D8 Average 1o9inCs J >o6 >o6 =arnings Volatility # ' & 0igh =arnings Volatility Difference %>o6)0igh( P)value '+346 #+64 1+$'4 1+3'$ 1+''6 #+& ! %!+!! ( =arnings >evel Juintile # ' & 1+ 3$ 1+#3 1+' # 1+1!& 1+11 !+&6& %!+!!( 1+ 36 1+''' 1+'34 1+11& 1+!&& !+ '# %!+!! ( 1+$ 1+3#4 1+ #1 1+'&4 1+1 !+4!1 %!+!!( 0igh #+ ! #+1# 1+366 1+ 6 1+133 1+'3' %!+!!(

Panel =8 Average 1o9inCs J >o6 >o6 =arnings Volatility # ' & 0igh =arnings Volatility Difference %>o6)0igh( #+'4 #+&#' #+#4# 1+413 #+&'1 )!+! "ash @lo6 Volatility # ' & 1+6&1 1+36& 1+443 1+$4' 1+&& !+#! 1+'& 1+ '# 1+ '' 1+614 1+ !& )!+16 1+!!& 1+1&3 1+#6 1+## 1+# 6 )!+# 0igh !+64' !+4'$ !+$&& !+$&$ 1+!! )!+'# '3

P)value

%!+$! (

%!+1#(

%!+1$(

%!+!'(

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'4

+a$le ) .ooled Regressions 1he ta9le ;resents results fro/ ;ooled regressions of the natural logarith/ of 1o9inBs Q, a ;roxy for fir/ value, on cash flo6 and earnings volatility along 6ith /easures ca;turing ris: and gro6th o;;ortunities+ All regressions include #)digit SA" controls and all varia9les are defined in A;;endix 1+ De;endent varia9le8 ln%1o9inCs Q( %1( ln%=arnings Volatility( ln%"ash @lo6 Volatility( ln%Syste/atic ,is:( ln%@ir/)s;ecific ,is:( ln%1otal Assets( ,eturn on Assets Sales Gro6th "AP2)to)Sales De9t)to)1otal Assets ,KD)to)Sales Advertising)to)Sales "onstant Rear Andicator %1$43( Rear Andicator %1$$#( Ad7+ ,# )!+1'! %)1!+$1( !+16$ %1'+64( !+141 %16+ !( !+!!$ %!+3'( )!+!1& %)1+#1( !+##6 %13+ !( !+!3$ %3+# ( !+#4' %#+1!( )!+ 11 %)14+43( )!+'3! %)1&+&1( !+#'3 )!+!& %)'+$'( )!+!6& %)&+64( )!+13# %)1#+3&( !+1 6 %1#+ 6( !+133 %16+1'( !+!11 %!+4$( )!+!!3 %)!+6#( !+#'# %13+$#( !+!4! %3+'4( !+'## %#+'$( )!+ 33 %)#!+!1( )!+&'$ %)1 +4$( !+#&# )!+!&& %)'+44( )!+!1' %)!+$&( )!+11! %)3+$&( !+1&6 %11+4$( !+1 %1&+1$( !+!#! %1+6'( !+!!' %!+#4( !+#14 %13+!6( !+!33 %3+#!( !+#6& %1+$$( )!+ $6 %)#1+!1( )!+&'1 %)1 +4 ( !+#6

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+a$le / %nnual Regressions 1he ta9le ;resents results fro/ annual regressions for the three years utiliDed in the analysis+ 1he de;endent varia9le is the natural logarith/ of 1o9inBs J, a ;roxy for fir/ value+ All regressions include #)digit SA" controls and all varia9les are defined in A;;endix 1+ De;endent varia9le8 ln%1o9inCs J( 1$43 ln%=arnings Volatility( !+! & %1+3 ( ln%"ash @lo6 Volatility( ln%Syste/atic ,is:( ln%@ir/)s;ecific ,is:( ln%1otal Assets( ,eturn on Assets Sales Gro6th "AP2)to)Sales De9t)to)1otal Assets ,KD)to)Sales Advertising)to)Sales "onstant ? Ad7+ ,# )!+#4# %)4+$!( )!+!&$ %)#+!4( !+!14 %!+4&( )!+13& %)6+4'( !+1$# %3+$4( !+1'6 % +$'( !+!# %1+!6( )!+!6# %)#+34( !+#1# %4+&$( !+1!$ %&+$4( 1+1& %&+ 3( #,13 !+#&&

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+a$le 0 !ash 'low and Earnings 1olatility 2uintiles 1his ta9le ;resents results fro/ regressions of the natural logarith/ of 1o9inBs J, a ;roxy for fir/ value, 9y cash flo6 %;anel A( and earnings %;anel B( volatility Fuintiles deter/ined on an annual 9asis on either cash flo6 or earnings volatility and other /easures ca;turing ris: and gro6th o;;ortunities+ All regressions include #)digit SA" controls and all varia9les are defined in A;;endix 1+

Panel A8 "ash @lo6 Volatility 1 %>O5( "oeff+ =st t)stat )!+!&6 )1+31 )!+!'& )1+# !+!!& !+16 !+!&& 1+&4 )!+!$3 !+16& !+!#! )!+11' !+!'6 !+!1& !+1 ' )!+&11 )!+#41 )'+&! 6+'# !+6# )&+'4 1+!$ !+ # !+ $ ) +43 )&+'4 # "oeff+ =st )!+!#' )!+!&! )!+!'4 !+!1$ !+#&6 !+#1 !+!#& )!+! ! !+#!6 !+114 !+11$ )!+6'$ )!+&#6 "AS0 @>O5 VO>A1A>A1R JUA?1A>= ' & t)stat "oeff+ =st t)stat "oeff+ =st )!+4 !+!#4 1+!' !+!&$ )1+ # )!+! & )#+1' )!+!#4 )1+13 )!+!#6 )!+41 )!+!&# !+61 !+!#' !+3$ )!+!$! 11+6 $+1! !+'1& 6 !+'6' 4+'$ !+13' 6+$6 !+16# !+44 !+!' 1+#1 !+!3 )1+$& !+!## !+46 !+1#! 1#+$ 3+' !+'&4 ' !+## &+4! !+!$' '+4& !+1#3 !+&! !+&#$ 1+'# !+! 3 )$+ 4 )!+ #1 )4+!# )!+ 3' )6+64 )!+''4 ) +&' )!+&$1 %0AG0( "oeff+ =st t)stat !+!# 1+!& )!+!'& )1+ ! )!+11! )'+$# )!+1$ )3+#! 1'+4 !+''' & !+1'! +4& !+!61 #+&' !+#'' $+3! 1!+4 !+#63 # !+!6' #+36 !+&1! 1+6' )!+ 33 )$+$3 )!+'$1 )6+$3

Varia9le ln%=arnings Volatility( ln%Syste/atic ,is:( ln%@ir/)s;ecific ,is:( ln%1otal Assets( ,eturn on Assets Sales Gro6th "AP2)to)Sales De9t)to)1otal Assets ,KD)to)Sales Advertising)to)Sales "onstant Rear Andicator %1$43( Rear Andicator %1$$#(

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+a$le 0 ,!ontinued!ash 'low and Earnings 1olatility 2uintiles Panel B8 =arnings Volatility 1 %>O5( "oeff+ =st t)stat )!+'#& )1#+1& )!+!&# )1+61 )!+! )1+4! !+!$# '+! !+!! !+1$ !+133 3+#$ )!+!'1 )1+1# )!+113 )&+3$ !+!$ '+'! !+!'1 1+#3 )!+1!# )!+&& )!+6&' )$+3# )!+&#6 )6+4 1,'$$ !+#3 =A,?A?GS VO>A1A>A1R JUA?1A>= # ' & "oeff+ "oeff+ "oeff+ =st t)stat =st t)stat =st t)stat )!+''6 )1#+'6 )!+' ! )1&+!# )!+#$! )11+#6 )!+! 6 )#+#1 )!+!&6 )1+$' )!+!&1 )1+3# )!+! ' )1+6 )!+!&$ )1+6 )!+!#4 )!+$4 !+!'! !+$' )!+!14 )!+61 )!+!3! )#+&' !+#' 4+#1 !+#&! $+&$ !+# 1!+!$ !+1&& +3! !+#!6 $+&# !+14 4+!4 )!+!4! )#+6$ !+! #+# !+!61 #+' )!+!14 )!+3' )!+!1' )!+ 6 !+1!$ &+ $ !+#6& 4+&& !+### 4+'$ !+#&! $+16 !+!$6 '+$6 !+!$4 &+&# !+!$' &+!& !+6 # #+1' !+&3# 1+!' !+1#& !+& )!+6$3 )1!+'6 )!+3!' )11+ 1 )!+611 )1!+!3 )!+ $ )4+44 )!+&$$ )4+ ! )!+& 3 )3+4& 1,&!! !+#4 1,'$$ !+'4 1,&!! !+' %0AG0( "oeff+ =st t)stat )!+1 ' )6+'# )!+! # )#+1& )!+!63 )#+#4 )!+#63 )$+! !+#'3 $+1! !+11& &+33 !+!#& !+44 !+1& +43 !+#$ 1!+$1 !+!'$ 1+6& !+ &1 1+$ )!+ #3 )4+ & )!+&1! )6+44 1,'$$ !+'#

Varia9le ln%"ash @lo6 Volatility( ln%Syste/atic ,is:( ln%@ir/)s;ecific ,is:( ln%1otal Assets( ,eturn on Assets Sales Gro6th "AP2)to)Sales De9t)to)1otal Assets ,KD)to)Sales Advertising)to)Sales "onstant Rear Andicator %1$43( Rear Andicator %1$$#( ? Ad7 ,#

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