Cost of Equity and Risk in Cash Flow and Accrual Components of Earnings
50 Pages Posted: 29 Jul 2010 Last revised: 11 Jul 2012
Date Written: July 1, 2012
This paper shows that risk in cash flow and accrual components of earnings is an important determinant of a firm’s cost of equity beyond risk in earnings. The paper develops and tests a model that demonstrates how earnings smoothing hinders the ability of earnings to capture firm risk and how cash flows and accruals can be used to unravel the effect of smoothing in estimating firm risk. The model also shows that the sensitivity of firm risk to risk in cash flows and accruals depends on the profit margin and the length of the operating cash cycle. The empirical results are generally consistent with the model findings. Relative to estimates of cost of equity based on volatility of earnings, estimates of cost of equity based on volatilities of cash flows and accruals result in lower valuation errors, lower valuation biases, and better explain future stock returns.
Keywords: cost of equity capital, cash flows, accruals, earnings, volatility, valuation
JEL Classification: M41
Suggested Citation: Suggested Citation