The Functional Relationships Among Earnings, Cash Flows and Stock Returns in Korea

This paper investigates the functional relationships between stock returns and two representative performance measures. The two measures are earnings and cash from operations. In addition, this paper assesses the association of stock returns with the decomposed components of earnings. Our study documents that earnings dominate cash from operations in terms of the relationships with the stock returns. When the stock returns are regressed on the decomposed components of earnings, cash from operations consistently shows strong positive relationships with stock returns. The efficient capital market hypothesis posits that changes in reported earnings without cash flow implications should not affect stock prices. However, our regression results indicate that non‐current accruals have strong relationships with the stock returns even though they lack cash flow implications. Perhaps this may imply that cosmetic earnings increases might be rewarded with increases in stock prices.