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. Using the COVID-19 pandemic as an exogenous shock that exacerbates fundamental uncertainty, we find that severe uncertainty leads investors to increase the valuation weight on cash flows and reduce the valuation weight on earnings. Consequently, while net earnings dominate operating cash flows in explaining the cross-section of stock returns during the pre-pandemic period, operating cash flows outperform net 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 accrual 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 ex-ante exposure to the pandemic shock and with the level of financial inflexibility. Moreover, we find that while analysts' earnings forecasts become less accurate and more dispersed during the pandemic period, their cash flow forecasts do not exhibit significant changes in forecast accuracy or dispersion over the same period. Our evidence highlights the relative importance of cash flows versus earnings under severe uncertainty about firms' prospects.