Is cash flow king?

Liu, Nissim and Thomas have recently published a paper in the Financial Analysts Journal, (Vol. 63, No. 2, pp. 56-65, 2007 to be exact) that shows that earnings does a better job than cash flow of explaining share prices. Here's the abstract of the paper:

Contrary to the common perception that operating cash flows are better than accounting earnings at explaining equity valuations, recent studies suggest that valuations derived from industry multiples based on reported earnings are closer to traded prices than those based on reported operating cash flows. The question addressed in the article is whether the balance tilts in favor of cash flows when the following are considered: (1) forecasts rather than reported numbers, (2) dividends rather than operating cash flows, (3) individual industries rather than all industries combined, and (4) companies in non-U.S. markets. In all cases studied, earnings dominated operating cash flows and dividends.

This is of course what we would expect. If (accrual-based) earnings didn't do a better job of explaining value (and summarising business performance generally), then we'd see accrual accounting disappear.

Note: UNSW students should be able to access the Financial Analysts Journal through Sirius at the UNSW Library webpage. [It's at the bottom left of the linked page].