Review of Accounting Studies, 7, 217–227, 2002
2002 Kluwer Academic Publishers. Manufactured in The Netherlands.
Discussion of “The Role of Volatility in Forecasting”
Columbia University, Graduate School of Business, 604 Uris Hall
Minton, Schrand and Walther (2002) (MSW) investigate whether cash ﬂow (earnings)
volatility helps predict subsequent levels of cash ﬂow (earnings). Price is the present value
of expected future cash ﬂows, so if cash ﬂow volatility forecasts future cash ﬂows (the
numerator in the present value calculation), it should have valuation implications. A similar
motivation applies to earnings, which may be viewed as a proxy for cash ﬂow.
Most previous studies that investigate the valuation implications of cash ﬂow volatility or
earnings volatility focus on the relation between volatility and the cost of capital (i.e., the
denominator in the present value calculation). Many studies have documented a positive
association between earnings volatility and risk measures such as market beta (e.g., Beaver,
Kettler and Scholes, 1970). Indeed, in a survey of research relating accounting numbers
to systematic risk, Ryan (1997) argues that earnings variability has historically been the
accounting variable most strongly related to systematic equity risk.
Other studies have
reported a negative relation between earnings volatility and the earnings coefﬁcient in either
price or return regressions (e.g., Collins and Kothari, 1989; Easton and Zmijewski, 1989;
and Barth, Elliott and Finn, 1999). These studies attribute the negative relation between
earnings volatility and the earnings coefﬁcient to the positive association between earnings
volatility and the cost of equity capital.
To my knowledge, MSW is the ﬁrst study that directly examines the relation between
cash ﬂow volatility and subsequent cash ﬂow levels. The authors hypothesize that cash ﬂow
volatility is negatively related to future cash ﬂows because market imperfections induce
a wedge between the costs of internal and external funds, and hence cash ﬂow volatility
increases the likelihood of underinvestment (relative to the cost of internal funds). Indeed, it
appears that ﬁrms’ investment decisions are sensitive to the source of funding. For instance,
using data from the 1986 oil price decrease, Lamont (1997) shows that oil companies
signiﬁcantly reduced their non-oil investment compared to the median industry investment,
and Minton and Schrand (1999) report that cash ﬂow volatility is negatively associated with
investments in ﬁxed assets, R&D and advertising.
Therefore, I believe that the research question is interesting and relevant. In fact, as MSW
point out (in their Section 2.1), there are additional explanations for a relation between
cash ﬂow volatility and future cash ﬂows, which make the research question even more
appealing. However, by focusing on the underinvestment effect, MSW provide only limited
evidence on the research question. In particular, while their results suggest that cash ﬂow
volatility helps predict future cash ﬂows, the evidence that the relation is due underinvest-
ment is weak.