An Exploration into the Value Relevance of Accrual Based Multiples Vs Cash Flow Multiples

Conor Dillon & Daniel Babak Yazdanshenas

Student thesis: Master thesis


The main motivation for this research thesis stems from the fact that despite multiples being used so much in the practice of investment analysis to predict firms’ market values, there appears to be a paucity of research in the area of accrual based multiples (P/E) versus cash flow multiples (P/OCF and P/D). Using multiples to value firms initially appears to be a quick and easy methodology; but it does raise certain difficulties. A review of extant literature suggests that equity based multiples are more value relevant than entity based multiples; contrasting research findings are also noted relating to the continuing relevance of P/E as well as to the size of comparable peer groups. The general theoretical, empirical and methodological focus adopted here, if in part, in addressing this research gap broadly follows Schreiner’s (2007) seminal four-step comprehensive multiples equity valuation framework model which is then applied to a more recent 2007- 2017 data time period across six business sectors (Energy, Industrials, Materials, Information Technology, Health Care and Financials) in the United States. The central specific focus of this thesis in terms of value relevance is to empirically test whether accrual (P/E) multiples are more precise than cash flow multiples (P/OCF and P/D). The question of how difference in capital structure and market capitalization may affect value relevance is also explored. A secondary focus relates to the question of comparable firms on the impact of peer group size. The main empirical findings lend strong support for Schreiner’s (2007) prior research for the later time period adopted here, as well as supporting Liu et al. (2002, 2005, 2006), in that accrual based multiples (P/E) are found to be more value relevant than cash flow multiples (P/OCF and P/D) across six GICS sectors. In a separate exploration of the different industries based on GICS Classification Level-3 for Health Care, Industrials, Energy, Financials and Information Technology, (P/OCF) price to operating cash flow multiples and (P/D) price to dividends multiples did not outperform (P/E) price to earnings ratio, with the exception of the Financials sector where (P/OCF) outperformed (P/E). The findings also support Alford (1992) and Liu et al. (2002) in that adjusting for differences in leverage fails to improve valuation accuracy. The findings are inconclusive on the question of whether differences in capital structure and market capitalization impact on value relevance both on Schreiner’s (2007) claim that different capital structures have a negative effect on the reliability of the multiples valuation approach. Particularly when working with equity value multiples, and on Alford’s (1992) claim that the distinction between small and large firms can make significant contributions. Apart from the Financials sector, no support is found here for Kang’s (2016) argument that P/E had lost value relevance in recent years. In terms of peer group size, strong support is found for Palepu et al.’s (2000) argument that the greater the comparable peer group size the more likely idiosyncrasies amongst firms cancel each other out. The thesis concludes, notwithstanding its methodological limitations, that multiples retain their value relevance for investor analysis.

EducationsMSc in Finance and Investments, (Graduate Programme) Final Thesis
Publication date2018
Number of pages154