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Analysts' cash-flow forecasts grow in number but shrink in accuracy, study finds

By all rights, these forecasts should be at a premium nowadays.

In the current economic environment, where cash is said to be king, investors might be expected to pay special heed to analysts' cash-flow forecasts, which usually accompany the earnings predictions they issue. But investors who do so are likely to be disappointed, according to the most comprehensive comparison to date of the two kinds of predictions.

In general, cash-flow forecasts "are of a considerably lower quality than earnings forecasts," concludes the report in the current issue of The Accounting Review, a scholarly publication of the American Accounting Association. They "are much less accurate and are less frequently revised... Further, they appear to involve little more than a naive extension of the accompanying earnings forecasts."

In sum, "the fact that these forecasts represent in essence a trivial extension of analysts' earnings forecasts and the evidence on the presence of serious data-quality issues are all relevant for investors who might consider using these forecasts in valuation and investment decisions," conclude the study's authors, Dan Givoly of the Smeal College of Business at Penn State University, Carla Hayn of the UCLA Anderson School of Management, and Reuven Lehavy of the Ross School of Business of the University of Michigan.

Analysts' cash-flow forecasts, almost invariably issued in conjunction with earnings forecasts, are a relatively new form of investor advice. Two decades ago, they were virtually unknown, but by last year they accompanied five out of eight analysts' earnings predictions. Whereas earnings forecasts include non-cash accruals (for example, credit sales are considered revenues), cash-flow forecasts estimate changes in business liquidity as reflected solely in cash transactions.

In their short history, analysts' cash-flow forecasts have elicited a fair amount of scholarship, even while attracting little attention in the business press. Some scholars have deemed them a valuable supplement to earnings forecasts and have interpreted analysts' growing propensity to issue them as a response to investor demand.  Although the new research does not rule out that possibility, it questions whether analyst cash-flow forecasts are generally of value to investors. As the authors tactfully put it, "While analysts might respond to what they perceive to be investor demand, the type of cash flow forecasts they produce does not fully meet this demand."

To arrive at that conclusion Givoly, Hayn, and Lehavy compared a sample of about 7,500 earnings forecasts and an equal number of cash-flow forecasts made by the same analysts within a 13-year period. They found that cash-flow forecasts made early in the year for the year ahead were less accurate than the contemporaneous earnings forecasts and that this accuracy gap became decidedly more pronounced for forecasts made late in the year.

Why the pronounced gap? True, cash flow is more volatile than earnings, and the quality of the data is somewhat inferior, the professors acknowledge. But they also conclude "that analysts take less care with and invest fewer resources in improving their cash-flow forecasts during the forecast period as compared with their earnings forecasts." In this regard, they note that analysts issue several times more earnings forecasts than cash-flow forecasts in the course of a year, which "likely indicates less frequent updating" of the latter.

The result in many cases, the authors say, is "a naive extrapolation of [the analysts'] earnings forecasts," reached simply by adding to their earnings estimates the totals for depreciation and amortization for the current year. "The finding that analysts' cash flow forecasts provide little incremental information beyond their earnings forecasts suggests that investors can easily replicate these forecasts," the authors observe.

Given that analyst cash-flow forecasts are a relatively new kind of offering, it would seem likely that they would improve in time as more experience and expertise are gained. Surprisingly, though, their accuracy "has actually declined over time," the professors find. "In contrast, the accuracy of analysts' earnings forecasts has improved over the same period, making the difference in their relative accuracy even more pronounced in recent years."

Moreover, updating beyond the 13-year period of the study (1993 through 2005) suggests no improvement in accuracy of cash-flow forecasts as of 2008.

How can investors seeking liquidity data in an economy where cash is tight distinguish forecasts worthy of attention from those that are not? Answers Givoly: "While detail does not guarantee accuracy, at least it suggests effort. Look for reports that at a minimum provide a projection of accruals, such as a projected change in receivables or inventories. Anything less should raise suspicions of a forecast issued merely to keep up with other analysts."

The study, entitled "The Quality of Analysts' Cash Flow Forecasts," is in the November/December issue of The Accounting Review, published six times a year by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA or its specialty sections include Accounting Horizons, Issues in Accounting Education, AUDITING: A Journal of Practice and Theory, Behavioral Research in Accounting, The Journal of the American Taxation Association, and The Journal of Management Accounting Research.



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