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«Leif Atle Beisland University of Agder Dissertation submitted to the Department of Accounting, Auditing and Law at the Norwegian School of Economics ...»

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There are several reasons why short term cash flow and earnings prediction tests may differ from value relevance studies. First, while the prediction studies typically analyse very short time horizons, company value is a function of all future cash flows/earnings. For instance, transitory earnings items may introduce noise (compare Kim et al., 2007) in current cash flow and earnings that render them unrelated to future cash flow and earnings even if they are statistically associated with stock return. Second, cash flow or earnings may be defined differently in empirical studies than in equity valuation models. For instance, the traditional cash flow model computes value as a function of free cash flow to equity. Equity value can also be expressed as a function of net financial assets and free cash flow from operations.

Nevertheless, most research focuses on cash flow from operations before investments. This research tradition uses another cash flow definition than the models that constitute the theoretical foundation of the empirical studies. Whether a change in cash flow definition towards free cash flow would materially alter the conclusions of prior research is an issue left for future research.

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–  –  –

Company value is the present value of future cash flows generated by the company. Several versions of the cash flow valuation model exist. However, regardless of the cash flow model used, company value is generally a function of future free cash flows. Still, when prior research analyses cash flows’ predictive ability and value relevance, the focus is almost exclusively on cash from operations before investments (Barth et al., 2001; Biddle et al., 1995; Dechow, 1994; Dechow et al., 1998; Finger, 1994; M. Kim & Kross, 2005; O. Kim et al., 2007; Rayburn, 1986; Subramanyam & Venkatachalam, 2007). This may seem like a paradox, particularly since the research maintains that it focuses on cash flows because they

are important drivers of company value; see the following statements from prior studies:

This study investigates the role of accruals in predicting future cash flows. A firm's ability to generate cash flow affects the values of its securities (Barth et al., 2001, p. 28).

Various explanations for the prominence of accounting earnings and the reasons for its usage have been offered.

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