Free cash flow (FCF) is the cash flow that firms are free to use based on the maintaining the existing production capacity of enterprises. Warren Buffett1 is the world's legendary stock investor, his unique, concise investment philosophy and strategies make him success. One of his eight investment principles is to investment firm which with low capital expenditure and high FCF, because FCF considered capital expenditures that the business required to fully maintain it long-term competitive position. Comparing to after-tax income, FCF could reflect the earnings belong to the shareholders more. That’s why Warren Buffett has referred to the FCF of a company as owner earnings. FCF has received much attention in recent years, and number of extensive use of FCF is limited to financial advice, credit ratings, investment banks and other institutions. This alternative view of FCF is often defined in the popular press:
‘Free cash flow is gaining in popularity as a tool investors can use to gauge a company's relative value.’, and ‘Free cash flow is a snapshot of past performance, it tends to have a strong relationship to future earnings.’(Forbes, 2006).
Financial statement analysis, firm managers, and investors frequently advocate examining the accrual earning per share (EPS) for the purpose of valuing the corporate (Chan, Chan, Jegadeesh and Lakonishok, 2006). EPS is the summary measure of corporate performance that produced under the accrual basis of accounting. For wide range of users, it becomes an important firm performance index.
However, EPS contain the component of the accruals2. Previous studies find that accruals improve the ability to measure the firm performance (Holthausen and Leftwich, 1983;
Watts and Zimmerman, 1986; Holthausen, 1990; Healy and Palepu, 1993; Krishnan, 2003).
But it may have problems, the managers would use their discretion to opportunistically manipulate accruals, earnings will become less reliable and cash flow could be preferable.
1 Warren Buffett is one of the most successful investors in the world, the primary shareholder and CEO of Berkshire Hathaway.
2 Accruals are the difference between earning and cash flow.
Thus, accruals principle gives the managers space to do the earning management (Healy, 1985; Teoh, Welch and Wong, 1998; Collins and Hribar, 2000).
Dechow(1994) examine three measurement intervals(quarterly, annual and four-yearly) by using Vuong’s Z-statistic3 to analyze earnings and cash flow which is a better estimate for valuing firm performance. The results are (1) over short measurement intervals earnings are more strongly associated with stock returns than are realized cash flows, and the ability of realized cash flow to measure firm performance improves relative to earnings as the measurement interval is lengthened. (2) Earnings have higher association with stock returns than do realized cash flows in firms experiencing large changes in their working capital requirements and their investment and financing activities. Under these conditions, realized cash flows have more severe timing and matching problems and are less able to reflect firm performance. Brown and Sivakumar (2003) compare the value relevance of two operating income. One of the two operating income is pro-forma (recurring operating) earnings reported by managers and analysts, and the other one is obtained from firms’ financial statements.
They use a Vuong’s Z-statistic to determine whether one valuation equation has a significantly larger adjusted R-square.The results suggest that operating earnings reported by managers and analysts are more value relevant than a measure of operating earnings derived from firms’ financial statements, as reported by Standard and Poor’ s. Shuto(2007) investigates the relation between discretionary accounting choices and executive compensation in Japanese firms. They also use a Vuong’s Z-statistic to compare the explanatory power of reported earnings for executive bonuses with that of nondiscretionary earnings (pre-managed earnings). The results show that the use of discretionary accruals increases executive compensation.
Shivakumar (2000) also finds evidence consistent with accruals earnings management around SEOs, he shows that the stock market does not react inefficiently to the upwardly
3 For more detail on the test developed by Vuong, see Appendix.
managed earnings, but that investors rationally undo these effects. He argues that the earnings management is not designed to fool or mislead investors, but is itself a rational response to the market’s anticipation that firms will upwardly manage earnings around the SEO.
Jensen (1986, 1989), Stulz (1990) and Gul and Tsui (1998) suggest that debt ratio plays an important role in agent problem. The low-growth opportunities firms with high debt ratio may reduce the opportunities that managers to do overinvestment, decreasing the agent cost in low-growth opportunities and high free cash flow firm. Jensen (1986), Richardson (2006) and Banker, Huang and Natarjan (2009) apply debt to equity ratio as leverage, so does our study.
Myers and Majluf (1984) develope pecking order theory and show how this asymmetry leads firms to prefer internal funds to external funds. When the former are exhausted and there exists a deficit in funds, firms will prefer safer debt to riskier equity.
Opler and Titman (1994), Majumdar and Chhibber (1999), and Weill (2008) find that leverage is negative with firm performance. Because it may generate a spurious negative correlation between leverage and performance since the poorly performing firms might be required to increase their borrowing to cover their losses. Therefore, leverage will add in our analysis to examine its effect on firm performance. Opler and Titman (1994), Maury (2006) mentioned that firm size is positive related to firm performance. When company size is large, means the company has in the mature stage, and it has more adaptability of industry changes than small scale.
For above reasons, this study wants to examine the EPS and FCF in firm valuation with control variables, like size and leverage. In addition, we will separate low and high-growth opportunities firms by P/E ratio to do the group analysis. For the global perspective, we choose the top six world economic markets bases on GDP to study, because sum of top six economic markets' GDP are almost 60% of sum of all the country in the world. Therefore, top six economic markets can be a proxy of the whole world. In this paper, if both EPS and FCF are significant to firm performance, we will apply the method of these literatures to analyze
which EPS or FCF has better explanatory power for firm performance.
Apart from these factors, corporate valuation may be driven by corporate governance (La Porta, Lopez-De-Silanes, Shleifer and Vishny (LLSV), 2002; Claessens and
Fan
, 2002;Lemmon and Lins 2003; Brown and Caylor, 2006; Chua, Eun and S. Lai, 2007; Bhagat and Bolton, 2008). Chua, Eun et al. (2007) provided a comprehensive analysis of corporate valuation around the world. To facilitate the comparison of corporate valuation across countries, Tobin’s Q is the variable as valuation measure. The main finding are the more transparent accounting, less corruption, lower country risk all contribute significantly to corporate valuation. Also, Tobin’s Q varies directly with shareholder’s rights, and enforcement of insider trading laws, and they have significant positive relationship with firm performance.
LLSV (2002) investigate the relationship between investor protection and corporate valuation, and document that investor protection affect corporate valuation, and poor shareholder protection is penalized with lower valuations. Claessens and
Fan
(2002) and Lemmon and Lins (2003) also show that firm value increases as the ownership of large shareholder increase. Lee and Ng (2003) investigate the relation between corruption and international corporate values, and find that there exists a significant negative relationship between country-level corruption and corporate valuation, it indicated that firm in lower corruption will has better firm performance. Morey, Gottesman, Baker and Godridge (2009) find country risk are significantly link with higher valuation. This study will add the corporate governance factors to construct the whole corporate evaluation more integrity.We use two main performance measures: Tobin’s Q and ROA. Previous study, Klapper (2004) and Wright, Kroll, Mukherji and Pettus (2009), also use Tobin’ Q and ROA as firm performance. Tobin’s Q is a measure of market valuation of firm, it is a market-based firm performance; and ROA is a measure of operating performance, it is an accounting-based firm performance.
The remainder of this paper is organized as follows. Section 2 describes the methodology including the sample selection and the research models. Section 3 presents and discusses the results and section 4 provides a summary of our main results and conclusions.