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Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns Explained

Last Updated on 10 February, 2024 by Rejaul Karim

Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns” is an academic paper by Ray Ball, Joseph Gerakos, Juhani T. Linnainmaa, and Valeri V. Nikolaev.

The paper explores the non-cash component of earnings, referred to as accruals, adjusting cash flows to create a measure of profitability largely impervious to the timing of cash flow movements. The authors confront two anomalies – the increase in expected returns with profitability and their decrease with accruals.

Their research asserts that cash-based operating profitability, which excludes accruals, appears to perform better than profitability measures that encompass accruals. They further highlight that prioritizing a cash-based operating profitability factor can significantly enhance an investment strategy’s Sharpe ratio.

Abstract Of Paper

Accruals are the non-cash component of earnings. They represent adjustments made to cash flows to generate a profit measure largely unaffected by the timing of receipts and payments of cash. Prior research uncovers two anomalies: expected returns increase in profitability and decrease in accruals. We show that cash-based operating profitability (a measure that excludes accruals) outperforms measures of profitability that include accruals. Further, cash-based operating profitability subsumes accruals in predicting the cross section of average returns. An investor can increase a strategy’s Sharpe ratio more by adding just a cash-based operating profitability factor to the investment opportunity set than by adding both an accruals factor and a profitability factor that includes accruals.

Original paper – Download PDF

Here you can download the PDF and original paper of Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns.

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Author

Ray Ball
University of Chicago – Booth School of Business

Joseph Gerakos
Tuck School of Business at Dartmouth College

Juhani T. Linnainmaa
Dartmouth College – Tuck School of Business; National Bureau of Economic Research (NBER); Kepos Capital

Valeri V. Nikolaev
University of Chicago Booth School of Business

Conclusion

In conclusion, “Cross Section of Stock Returns” fortifies the importance of cash-based operating profitability in financial analyses and investment strategies. The research focuses on accruals, the non-cash component of earnings, providing valuable insights into how their exclusion can enhance the prediction of average returns.

Furthermore, the study remarkably reveals that prioritizing cash-based operating profitability can prove more advantageous for increasing a strategy’s Sharpe ratio than considering both accruals and a profitability factor inclusive of accruals.

Therefore, the paper underscores the superiority of cash-based operating profitability measures over those that include accruals, signalling a pivotal shift in the approach towards emulating and predicting stock returns.

Related Reading:

Market Timing with Aggregate and Idiosyncratic Stock Volatilities

Moving Average Distance as a Predictor of Equity Returns

FAQ

What is the primary focus of the research paper “Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns”?

The primary focus of the research paper is on accruals, the non-cash component of earnings. The authors investigate how adjusting cash flows to create a measure of profitability that excludes accruals can enhance the prediction of average stock returns. They address anomalies related to expected returns increasing with profitability and decreasing with accruals, and explore the performance of cash-based operating profitability in comparison to measures that include accruals.

What does the research suggest about the relationship between accruals and stock returns?

The research suggests that cash-based operating profitability, which excludes accruals, outperforms measures of profitability that include accruals. The authors find that cash-based operating profitability not only performs better but also subsumes the predictive power of accruals in the cross-section of average returns. This indicates that the exclusion of accruals can lead to a more effective measure of profitability in predicting stock returns.

How does the paper contribute to understanding the anomalies related to expected returns, profitability, and accruals?

The paper contributes by providing insights into anomalies related to expected returns, profitability, and accruals. It addresses the observed anomalies and demonstrates that cash-based operating profitability, which excludes accruals, is a superior measure. The findings suggest that investors can achieve a more robust investment strategy by prioritizing cash-based operating profitability, which contributes to a better understanding of the complex relationships in the cross-section of stock returns.

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