Are Analysts' Cash Flow Forecasts Naïve Extensions of Their Own Earnings Forecasts?

Abstract

We examine the sophistication of analysts' cash flow forecasts to better understand what accrual adjustments, if any, analysts make when forecasting cash flows. As a preliminary step, we first demonstrate that prior empirical tests used to evaluate the sophistication of analysts' cash flow forecasts are not diagnostic. We then present three sets of evidence to triangulate our conclusion that analysts' cash flow forecasts incorporate meaningful accrual adjustments. First, we review a stratified random sample of 90 analyst reports and find that the majority of these analysts include explicit adjustments for working capital and other accruals in their cash flow forecasts. Second, using a large sample of analysts' cash flow forecasts from 1993–2008, we find that these forecasts outperform time‐series cash flow forecasts in correctly predicting the sign and magnitude of accruals. Finally, we find a significant market reaction to analysts' cash flow forecast revisions, suggesting that investors find these revisions informative. Collectively, our findings demonstrate that analysts' cash flow forecasts are not simply naïve extensions of their own earnings forecasts, but that they reflect meaningful and useful accrual adjustments. These findings are relevant to researchers who examine analysts' cash flow forecasts in a variety of settings, and to investors and practitioners who employ these forecasts for valuation purposes.

Do Analysts' Cash Flow Forecasts Encourage Managers to Improve the Firm's Cash Flows? Evidence from Tax Planning

“…In recent years, the literature on analysts' cash flow forecasts has explored a variety of issues related to analysts' cash flow forecasting activities. These topics include country‐level institutional factors that predict the incidence of analysts' cash flow forecasts (DeFond and Hung ), analyst‐level determinants of cash flow forecast issuance (Ertimur and Stubben ), the market pricing of cash flow surprises (Brown et al ), the effect of analysts' cash flow forecasts on the pricing of operating cash flows (Call ) and on market efficiency (Mohanram ; Radhakrishnan and Wu ), the benefit of forecasting cash flows on analysts' earnings forecasts and on analyst turnover (Call et al ; Pandit et al ), and the underlying quality of analysts' cash flow forecasts (Givoly et al ; Call et al ).…”

“… Similar to the adjustments analysts make when forecasting earnings, they make adjustments to their cash flow estimates to produce a forecast that is most relevant to the firm in question (Call et al ). Similar to what is done when reporting actual earnings, I/B/E/S defines the actual cash flow value based on the exclusions made by the majority of analysts following the firm (Givoly et al ).…”

Do Analysts’ Cash Flow Forecasts Improve Their Target Price Accuracy?

“… Mangen () refers to the moving target problem in questioning Call et al's () tests of analyst sophistication based on the accuracy of cash flow and accruals forecasts; namely, if firms manage reported cash flows or accruals, forecast accuracy depends on analysts’ ability to anticipate this and on their incentives to incorporate it into their forecasts. This problem is less of an issue when comparing target prices with market prices. …”

Discussion of “Are Analysts' Cash Flow Forecasts Naïve Extensions of Their Own Earnings Forecasts?”

“…Call, Chen, and Tong () explore whether analysts are sophisticated when forecasting cash flows. To start, they replicate and critique a test from Givoly, Hayn, and Lehavy that suggests a lack of sophistication in cash flow forecasts.…”

“…, Call et al. () find that analysts, when forecasting cash flows, adjust earnings for depreciation, yet fail to take into account working capital and other accruals. However, Call et al.…”