The effect of cash flow added (CVA) on annual stock prices in Amman stock exchange.

Author:Al-Shattarat, Husni K.


Managers adopt strategies to maximize the value of their organization, which aims to maximize the shareholder's wealth through optimum allocation of resources. In order to achieve this goal, researchers and practitioners used many criteria as indicators to evaluate their performance taken to maximize this wealth, standard accounting criteria such as operating income (net operating income) and fiscal ratio such as return on asset and return on capital where used to achieve these aims.

Many years ago most companies realized that methods based on discounted cash flow must be used for investment analysis or when valuing the future. However, for ongoing financial performance measurement, the investor's cash flow based perspective (profitability, value creation in companies which depends on the funds initially invested in one or many ventures, operating cash flows generating from those venture, and its economic lives and capital costs) is substituted with the accountant's accrual accounting perspective. Where, this situation is not an acceptable for management.

The necessary components of a valuation--based research design is a valuation model linking firm's value to firm--specific characteristics that investors are assumed to value. This is the key to make a link between firm value and accountings figures. Researchers used a wide range of valuation models in practice, from simple to the sophisticated. The main valuation method can be classified in four groups, Fernandez (2001): balance sheet models (book value of equity), income statement methods, value creation methods, and options methods. To determine which one of these methods is suitable to use, that will be based on whatever information might be available to the decision-maker.

Corporate managers now face a period where a new economic framework that better reflects value and profitability must be implemented in their companies. Accounting systems, which has been used up until today, are insufficient and will not stand the challenge from the increasingly efficient capital markets and owners. The increased efficiency at the capital markets requires that capital allocation within companies become more efficient and it is therefore not possible for companies to allocate capital in the future as inefficient as they do today. A new economic framework, a Value Based Management framework that better reflects opportunities and pitfalls, is therefore necessary.

The currently professional innovation, which has been occurred in the field of evaluation of domestic and foreign function, is the generation of surplus cash dividend criteria which is known under the title of Cash Value Added (CVA, hereafter), Ottosson and Weissenrider (1996), claimed that operating profit, net profit and the growth of profit are the misleading criteria of company's function and the best measurement criteria of periodic function is cash value added.

The summarized empirical results were nevertheless contradicting to the wide practical use of accounting earnings by market participants and analysts. Given the fact, that many methodological improvements and sophistication of statistical models provided seemingly little contribution to the enhancement of the explanatory power of earnings, researchers began to discuss the value-relevance of the information content of reported earnings as possible reasons for such results. The issue is that in most empirical studies the accounting income numbers were taken as face values while there is a good sense to suppose that the reported values are largely adjusted by market participants before making investment decisions. The reason is that there exist a large variety of measurement and valuation techniques, different treatments of the same rules as well as earnings manipulations by management of a firm which bias the true picture and deteriorate the informational content of reported income numbers. From this point, the earnings/returns relationship became an issue for accounting researchers and the explanatory power of accounting income was used to measure the capacity of different accounting rules to represent the real economic performance of publicly traded companies.

Because there is no consensus among researchers upon typical performance measure (accrual earnings or cash flows items), the relation between both accrual earnings and cash flows items with firms performance which measured by stock return or equity valuation, is one of the most important relation that have long been investigated by the prior research (as will be discussed in chapter two). While there are few Jordanian studies that discuss the share--price relationship, to the knowledge of the researcher, there is no attempt made to compare between cash value added and other cash items on the basis of their association with annual stock prices. Therefore, this study will try to bridge this gap.

This study contributes to this important area of research by examining the relevance of the information content of cash value added CVA and both operating profit OP and cash flow from operating activities OCF in explaining value of the firm and to test whether the CVA has incremental information content beyond OP and OCF. Furthermore, this study attempts to measure (quantify, enumerate) the valuable information of released data about cash value added in accounting reports and to find out whether these released information can be linked to change in stock's price.


Over the last decade a large number of accounting paper investigated the empirical relation between equity value and particular accounting numbers for the purpose of assessing firm's performance. It is well known that many studies been investigated the association of earnings with annual stock price (or return). Among other, the comparison with the value relevance of cash flows is a very important research issue. Most prior comparative accounting value relevance studies in the area of accrual (earnings) versus cash flow informatory value focus on the comparison of accounting earnings versus cash flows (e.g. Dechow, 1994, and Aharony et al, 2003).

Management typically has some discretion over the recognition of accruals. This discretion can be used by management to signal their private information or to opportunistically manipulate earnings. However, to the extent that management uses their discretion to opportunistically manipulate accruals, earnings will become a less reliable measure of a firm performance and cash flows could be preferable. Accordingly, investigating the relation between accounting numbers and market requires a measure of value. Two types of models are commonly used to investigate this relation, namely the price model (valuation model) and the return model. The price model examines the relation between stock price, book value, earnings, and cash flows, where the return model examines the relation between stocks return, earnings and earnings changes. Rees (1999) exposed that there are some difficulties can be expected in the return model. These problems can be avoided by using the price models. Hence, share prices have became the most common value measured used in financial and accounting research. The relation between accounting numbers (earnings and cash flows) and firms performance that can be measured by stock price or equity valuation, is one of the most important relation that have long been investigated by the prior research. Most empirical studies focused on US and UK market, where a few studies focused in the same field here in Jordan.

Also, numbers of capital market research indicated and provided evidence that accounting earnings announcements have some impact on share prices. Brown (1994) stated that if share prices anticipate earnings announcement, then we are effectively 'looking back the other way' from tradition perspectives that assume that earnings announcements actually drive share price changes. One of the main study that directly test the information content of cash flows relative to accounting earnings was Dechow (1994) who investigated how well accounting earnings reflect market returns. Dechow also consider whether another measure of performance, based in cash flow, relates better to return than earning based in accrual accounting system. According to Dechow, earnings are predicted to be more useful and strongly associated with stock returns (a measure of firm performance) than are realized cash flows because they are predicted to have fewer timing, and matching problems. In this context, Riahi (1993) investigated the relative and incremental information content of some variable under the title of information content of value added, profit and cash flows. He concluded in surveying of relative information content that value added has more power of explanation in relation to general return of stocks. Riahi (1993) introduced the combination of value added and with net profit as the best combination of criteria in explanation of stocks return in surveying of incremental information content. Clubb (1995) investigated the incremental information content of earnings and cash flow measures. He used operating cash flows, financial and investing cash flows as variables for cash flows. He indicated that earnings, cash and fund flow had information content in relation to the company shares price. Earnings components (long -term accruals and working capital from operations) together had incremental information content beyond that in aggregate earnings and unexpected cash variables. Similarly, Ali (1994) found that, within the linear model the results is inconsistent with prior studies where the earnings and working capital from operations having incremental information content beyond cash flows, whereas cash flows incremental information content exist with non linear relations. These results suggested that nonlinear model better specified the association between stock return and...

To continue reading