Earnings Versus Cash Flows in Equity Valuation: Evidence from the COVID-19 Crisis

This study investigates the role of earnings and cash flows in equity valuation under severe uncertainty about firm fundamentals. We hypothesize that the valuation weight on cash flows (earnings) increases (decreases) with the degree of fundamental uncertainty because earnings, which include accounting accruals, become noisier than cash flows in an unstable economic environment and the market value of internal liquid resources increases with external financing frictions. Using the COVID-19 pandemic as an exogenous shock that exacerbates fundamental uncertainty, we find that while earnings dominate cash flows in explaining the cross-section of stock returns during the pre-pandemic period, cash flows outperform earnings during the pandemic period. We also find that the decrease in the value relevance of earnings is attributable to the decline in the valuation weight on the accruals component of earnings. Further analyses reveal that the dominance of cash flows over earnings is less pronounced for operating earnings than for net earnings and that the valuation weight on cash flows increases with the ex-ante exposure to the pandemic shock and the level of financial inflexibility. The overall finding supports the superiority of cash flows over accrual-based earnings as a firm performance metric during the COVID-19 crisis. Our evidence highlights the relative importance of cash flows versus accounting earnings under extreme uncertainty about firms’ prospects.