Cross-Firm Heterogeneity and Cash Flow Volatility in Explaining Earnings' Future Cash Flows Predictability

Document Type


Publication Date

Spring 2012


We find that the R² of time-series regressions of next-year cash flows on current- year earnings has not significantly changed over time. This lack of change in the R² of time-series regressions contrasts with a dramatic increase over time in the R² of cross-sectional regressions reported in prior studies. We provide evidence that cross-firm heterogeneity in the relation between next-year cash flows and current-year earnings has significantly decreased over time, which is consistent with the increase in the R² of prior studies' cross-sectional regressions. Further tests show that the pattern over time of cash flow volatility serves as another factor associated with cross-sectional variation in the increase over time in earnings' ability to predict future cash flows. Given our findings on diminished cross-firm heterogeneity and cash flows volatility, it is premature to suggest that evidence on earnings' increased ability to predict cash flows conflicts with other evidence showing a declining value relevance of earnings in the literature

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