Understanding earnings quality - MIT Sloan School of Management

3.1.1 Persistence of earnings and models of accruals
Studies of earnings persistence and cash flow predictability are motivated by an assumption
that persistence (or predictability) improves decision-usefulness in an equity valuation context, in
particular in models that are variants of neoclassical discounted dividend (DD) models. Model
variants based on dividends, cash flows, and earnings are theoretically equivalent under specific
assumptions about the relations between dividends, cash flows, and earnings (Penman, 1998;
Penman and Sougiannis, 2000; Lundholm and O’Keefe, 2001). While theoretically equivalent, the
models deviate in their ability to predict fundamental firm value in practice. The deviations depend
on the degree of conformity of observable model inputs with the model’s underlying assumptions
and on the sensitivity of the valuation to this conformity. In particular, the computation of the
terminal value, which is a significant component of the valuation, depends critically on assumptions
about growth and persistence.
Penman and Sougiannis (1998) provide evidence on the comparative decision usefulness of
the models, which in turn has implications for assessing the benchmark that should be used to
evaluate the decision usefulness of an earnings number. In summary, they conclude that over
various time horizons, in models with and without a terminal value assumption, models that apply
simple forecasting assumptions to earnings provide a better forecast of current market value than
models based on cash-flow or dividend forecasts. However, the point is that an assessment of
whether cash flow predictability or earnings persistence is a better measure of decision usefulness in
equity valuation depends as much on the proxy as it does on the decision model. In other words,
being able to predict one-year-ahead cash flows may be an irrelevant measure of quality if cash flow
based equity valuation models produce high prediction errors.
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