The Superiority of Earnings Over Cash Flows in Predicting Cash Flows Available to Investors Over the Long Run

Recent research has reignited the debate over whether earnings or cash flows better predict future cash flows. These studies and prior work generally focus on predicting future operating cash flows over the short run (one to three years ahead). In contrast, we examine the ability of earnings versus cash flows to predict cash flows available to investors after investment outlays over the long run (up to 20 years), which have a greater impact on equity valuation than near-term operating cash flows. We show that earnings dominate cash flows in predicting free cash flows over the long run, and this superiority is attributable in part to earnings’ inclusion of long-term investment accruals. We also find the superiority of earnings over cash flows and the importance of long-term investment accruals are more pronounced among firms with more volatile investment activities and longer investment cycles. Overall, our results help explain why earnings, not cash flows, are the predominant metric used for valuation and contracting purposes.