Do Accounting Earnings or Free Cash Flows Provide a Better Estimate of Capital Gain Rates of Return on Stocks?

There are two widely accepted approaches used to estimate the market value of a firm's equity (Vs). The accounting approach assumes the estimated Vs is based on the discounted value of a firm's future net income stream (NI). A finance model assumes that the value of a firm's stock (Vs) is related to the performance of its discounted future free cash flows to equity (FCFE). The motivation of this paper is to discover whether the accounting earnings approach or the finance FCFE approach provides a better explanation for estimating the capital gain rates of return on American and Japanese equities. Three sets of hypotheses were developed and regression analysis was used to test the hypothesized relationships. Financial data from a large sample of American and Japanese companies provided the information for testing the hypotheses. The regression results found a strong statistical relationship existed between net earnings and capital gain rates of return for both American and Japanese companies. However, the Fama-MacBeth t value was only significant for the Japanese data, which cast doubt on the predictability of the net earnings approach based on American data. The study found the free cash flow to equity measure was not closely related to the capital gain rates of return for either the American or Japanese companies. However, a strong relationship was discovered to exits between the capital gain rates of return and the cash flow associated with operations, interest and financing for the American companies. Cash flows related to net investment and working captial were not consistently related to the capital gain returns for American and Japanese companies.