Do investors fully understand the economic implications of cash flows from operations

This dissertation investigates the forecasting ability and persistence with respect to future cash flows of four cash components, the inclusion of which with Cash Flows from Operating Activities have the potential to generate misleading signals about the company's financial picture. It also examines whether market participants fully reflect the cash components' respective implications for future cash flows. Current operating cash flows play an important role in assessing future economic conditions and security values. The GAAP-based rules or flexibility faced by managements for reporting operating cash flows can potentially mislead investors in their assessments. Four components of operating cash flows are collected from fiscal years 1988--2000 for firms in the Fortune 500 index as of 2001: (1) nonrecurring cash flows, (2) tax benefits realized from nonqualified employee stock options, (3) investment-type cash outflows---R&D expenses and cash outlays involved in restructuring activities, and (4) cash proceeds from selling or securitizing accounts receivables. The dissertation documents that these operating cash components possess incremental value in predicting future cash flows over total operating cash flows and accrual components. They also differ in persistence from other operating cash flows coming from companies' core and continuing operations. Furthermore, hedge portfolios using the information in tax benefits realized prior to the year 1999, research and development expenses and transactions of selling or securitizing accounts receivables can separately earn positive abnormal returns over the subsequent six months up to three years. Their return predictive abilities persist after controlling for factors previously documented to predict returns. The empirical findings indicate that the stock market may not fully appreciate future economic implications of components of current operating cash flows. Further analysis verifies that the market mispricing is partially due to failures to fully impound the future cash flow information (not necessarily future earnings information) contained in the operating cash flow components.