Cross-Firm Heterogeneity and Cash Flow Volatility in Explaining Earnings' Future Cash Flows Predictability

We find that the R^sup 2^ of time-series regressions of next-year cash flows on current-year earnings has not significantly changed over time. This lack of change in the R^sup 2^ of time-series regressions contrasts with a dramatic increase over time in the R^sup 2^ of cross-sectional regressions reported in prior studies. We provide evidence that cross-firm heterogeneity in the relation between next-year cash flows and current-year earnings has significantly decreased over time, which is consistent with the increase in the R^sup 2^ of prior studies' cross-sectional regressions. Further tests show that the pattern over time of cash flow volatility serves as another factor associated with cross-sectional variation in the increase over time in earnings' ability to predict future cash flows. Given our findings on diminished cross-firm heterogeneity and cash flows volatility, it is premature to suggest that evidence on earnings' increased ability to predict cash flows conflicts with other evidence showing a declining value relevance of earnings in the literature. [PUBLICATION ABSTRACT]