THE RELATIONSHIP BETWEEN SHARE

PRICE AND OPERATING CASH FLOW

UNDER THE CASUAL THEME
RESTAURANT SETTING

Ruixue Du

Thesis submitted to the Faculty of the Virginia Polytechnic Institute and State
University partial fulfillment of the requirements for the degree of Master of
Science In Hospitality and Tourism Management

Michael D. Olsen, Ph.D.; Chair

Raman Kumar, Ph.D.
Francis Kwansa, Ph.D.

5/6/2008
Blacksburg, Virginia

Key Words: Share Price, Operating Cash Flow, Multiple Valuation, Earnings, Efficient
Market Hypothesis
 THE RELATIONSHIP BETWEEN SHARE PRICE AND
OPERATING CASH FLOW
UNDER THE CASUAL THEME RESTAURANT
SETTING

Ruixue Du

(ABSTRACT)

In spite of the well-accepted belief of the relationship between cash flow and stock

price, there are some controversies about whether cash flow is a good value driver in

terms of explaining the volatility of stock prices, when compared with other value drivers,

such as earnings or dividends.

Most of the previous studies that have focused on the relationship between stock price

and cash flow have used cross-industries data, primarily S&P 500 index. These studies do

not distinguish service industry from manufacturing industry.

However, the service industry is different from manufacturing in many ways. These

differences make cash play different roles in the daily operation between the service

industry and the manufacturing industry.

Given these factors, whether the relationship between stock price and cash flow

indentified in previous studies will hold in the casual theme restaurant industry is the

question this study tries to answer. Therefore, a set of 20 casual theme restaurant

companies are selected through the COMPUSTAT database as the sample of this study.

In this study, the performance of cash flow, earnings and dividends helping to explain

the stock price move will be compared and ranked under the setting of casual theme

restaurants. This result will provide the management of casual theme restaurants a
guideline, which explains how to maintain the stock price increase and minimize the

volatility by monitoring the most important value driver of the industry.

The methodology of this study will follow the traditional multiple valuation model.

The logic of this model is to compare the pricing error of different value drivers and

determine which one is the best.

The results of this study show that operating cash flow outperformed earnings and

dividends in the multiple valuation tests. This is different from the results of previous

studies that earnings has the strongest explanatory power in the variance of share price.

iii
 DEDICATION

I dedicate this work:

To my parents: Shuliang Du and Fangming Zhu

iv
 ACKNOWLEDGEMENT

I would like to express my deepest and sincere gratitude to my committee members

who provided invaluable guidance, suggestions and support of my study, without which

this thesis would not have been possible.

First of all, I would like to express my sincerest thanks to my advisor, Dr. Olsen, for

his guidance, encouragement, inspiration and patience. He has been providing valuable

help continuously, even during the periods that he was under medical treatments.

I also owe a deep debt to my committee members Dr. Kumar and Dr. Kwansa. Dr.

Kumar provided precious advice and support, especially on the data collecting and

analysis with his expertise on the COMPUSTAT dataset. I also thank Dr. Kwansa for his

advice and help on my thesis, especially on building the connection between the literature

review and my research questions.

Special thanks to my family and my friends who have been constantly supportive

during the entire process.

Thank you.

v
 Table of Contents
DEDICATION.................................................................................................................. iv

ACKNOWLEDGEMENT .................................................................................................v

TABLE OF CONTENTS ................................................................................................ vi

CHAPTER ONE ................................................................................................................1

INTRODUCTION..............................................................................................................1

Problem Statement ......................................................................................................................1

Purpose of This Study ...................................................................................................................2
Methodology Used in This Study .................................................................................................3
Results ..........................................................................................................................................3
CHAPTER TWO ...............................................................................................................4

LITERATURE REVIEW .................................................................................................4

Part I Body of Literature ..............................................................................................................4

Stock Price Determination ...........................................................................................................5
Case 1 ...........................................................................................................................5
Case 2 ...........................................................................................................................5
Case 3 ...........................................................................................................................6
Stock Price Valuation Models ......................................................................................................6
Efficient Market Hypothesis ......................................................................................6
Arguments Concerning the Validity of the EMH ....................................................9
Variance Bounds Tests .............................................................................................10
Debates on Variance Bounds Tests .........................................................................12
Valuation Using Multiples ..........................................................................................................14
Cash Flow in Stock Price Valuation ............................................................................................14
Dividends VS Broader Cash Flow ..........................................................................14
Cash Flow VS Earnings ...........................................................................................15
Summary of Previous Studies .....................................................................................................17
Part II Industry Context...............................................................................................................18
Part III Propositions ....................................................................................................................21
CHAPTER THREE .........................................................................................................23
vi
METHODOLOGY ..........................................................................................................23

Part I Research Questions and Research Propositions ...............................................................23

Proposition 1 .............................................................................................................23
Proposition 2 .............................................................................................................24
Proposition 3 .............................................................................................................24
Part II Data Collection .................................................................................................................25
Firm Selection ...........................................................................................................25
Variables....................................................................................................................26
Part III Data Analysis ...................................................................................................................27
Value Drivers ............................................................................................................27
Multiple Valuation....................................................................................................28
Multiples Construction ............................................................................................28
Analysis Procedure ...................................................................................................30
Summary ...................................................................................................................32
CHAPTER FOUR............................................................................................................33

RESEARCH RESULTS ..................................................................................................33

Results ........................................................................................................................................33
Research Question 1 ................................................................................................33
Table 4-1 Descriptive Statistics of Three Multiples by Groups ...........................34
Table 4-2 One-Way ANOVA Results for Proposition One ..................................35
Table 4-3 Descriptives for Three Groups ...............................................................36
Table 4-4 Test of Homogeneity of Variances .........................................................37
Table 4-5 Multiple Comparisons for Three Groups .............................................38
Research Question 2 ................................................................................................40
Table 4-6 Paired Samples T Test ............................................................................40
Table 4-7 Descriptive Statistics of 320 Firms .........................................................41
Table 4-8 One-Sample Statistics..............................................................................41
Research Question 3 ................................................................................................42
Table 4-9 Multiple Valuation Test Results for All 320 Firm-years Samples ......42
Table 4-10 Results of Liu, Nissim and Thomas (2001) ..........................................43

vii
CHAPTER FIVE .............................................................................................................44

CONCLUSIONS AND DISCUSSION ...........................................................................44

Summary of Results and Discussion ...........................................................................................44

Research Question 1 ................................................................................................44
Research Question 2 ................................................................................................44
Research Question 3 ................................................................................................44
Implications for Managers ..........................................................................................................45
Limitations ..................................................................................................................................46
Suggestions for Further Studies .................................................................................................47
REFERENCES .................................................................................................................48

APPENDIX A Sample Firms ..........................................................................................50

APPENDIX B Descriptive Statistics of Three Multiples by Groups ...........................51

APPENDIX C SPSS Out Put for One-Way ANOVA for Proposition One ................52

APPENDIX D SPSS Output for Paired-Samples T Test .............................................55

APPENDIX E Descriptive Statistics of 320 Firms ........................................................56

APPENDIX F SPSS Output for One Sample T Test ....................................................57

viii
 Chapter One

Introduction

Problem Statement

In finance literature, stock price is believed to be linked to cash flow, and this is

supported by the definition of stock and other stock valuation theories, such as efficient

market hypothesis (Fama 1970).

In spite of the well-accepted belief of the relationship between cash flow and stock

price, there are some controversies about whether cash flow is a good value driver in

terms of explaining the volatility of stock prices, when compared with other value drivers,

such as earnings or dividends. From their research in 2001, Liu, Nissim and Thomas

stated that earnings are better than cash flows in explaining the stock price, using the U.S.

market data. This result also holds in international markets according to a later paper by

Liu, Nissim and Thomas them (Liu, Nissim et al. 2007).

However, most of the previous studies that have focused on the relationship between

stock price and cash flow have used cross-industries data, primarily S&P 500 index, such

as Famas famous paper on efficient market hypothesis, Shillers variance bound tests in

1981, Ackert and Smiths paper in 1993, and Lius paper in both 2001 and 2007. These

studies do not distinguish service industry from manufacturing industry.

1
 It is known that, the service industry is different from manufacturing in many ways,

such as intangibility, simultaneity of production and consumption, customer participation

in the production and delivery of the service, heterogeneity, and perish ability. These

features make the service industry different from the manufacturing industry in the

supply-demand relationship and the inventory management. The manufacturing firms

usually keep a large amount of inventory of raw materials as well as finished goods, and

they do a lot of credit buying and selling. However, casual theme restaurants are

generally viewed as a cash business. They hardly keep finished goods in inventory,

neither a lot of raw materials, like the manufacturing industry usually does. This makes

cash take a dominant role on a balance sheet, as well as in daily operations.

Purpose of This Study

Given these factors, whether the relationship between stock price and cash flow

indentified in previous studies will hold in the casual theme restaurant industry is the

question this study tries to answer. Therefore, a set of 20 casual theme restaurant

companies are selected through the COMPUSTAT database as the sample of this study.

In this study, the performance of cash flow, earnings and dividends helping to explain

the stock price move will be compared and ranked under the setting of casual theme

restaurants. This result will provide the management of casual theme restaurants a

guideline, which explains how to maintain the stock price increase and minimize the

volatility by monitoring the most important value driver of the industry.

2
Methodology Used in This Study

The methodology of this study will follow the traditional multiple valuation model,

which requires that the price of firm i (in the casual theme restaurants sample set) in year

t is directly proportional to the value driver:

pit t xit it (0-1)

Where xit is the value driver for firm i in year t , t is the multiple on the value driver and

t is the pricing error.

The logic of this model is to compare the pricing error of different value drivers and

to determine which one is the best.

Results

The results of this study show that operating cash flow outperformed earnings and

dividends in the multiple valuation tests, different from previous studies that earnings has

the strongest explanatory power in the variance of share price.

3
 Chapter Two

Literature Review

In this chapter, the previous research that addressed the relationship between stock

price and cash flow will first be discussed. Then, the differences between the

manufacturing industry and service industry will be compared and contrasted, and the

relationship between stock price and cash flow will be examined within a service industry

other than under a cross-industries setting. After that, this chapter will close with the

propositions of this study.

Part I Body of Literature

The research on the determination of stock price has been an active area for a long

time, ever since the very beginning stage of stock markets. What factors determine the

changes of stock price? The question has been answered variously from the animal

spirits of Keynes (Keynes 1936) to the Market Efficiency Hypothesis of Fama (1970).

The value of a stock theoretically can be calculated based on the definition of security

assets, by discounting all the future dividends with an appropriate discount rate. However,

stock price in the empirical world sometimes seems to be too volatile to align with this

calculation (Shiller 1981a).

Among all the stock valuation models, the Efficient Market Hypothesis, the most

famous model, will be discussed and the challenge brought by Shiller and other

economists about this model will also be mentioned. Then, different opinions regarding

4
the relationship between stock price and cash flow are presented. At the end of this

chapter, the performance of cash flow will be compared with other value drivers, such as

earnings and dividends regarding the volatility of stock price.

Stock price determination

An asset value is determined by the present value of its future cash flows. A stock

provides two kinds of cash flows. First, stocks often pay dividends on a regular basis.

Second, the stockholder receives the sale price when selling the stock. Based on the

different growth patterns that a certain stock will follow, there are three types of stock

price valuation models (Ross, Westerfield et al. 2008):

Case 1 (Zero Growth) The value of a stock with a constant dividend is given by

Div1 Div2 Div1

P0 (1-1)
1 R (1 R) 2 R

Here it is assumed that Div1 = Div2 = = Div. This is just an application of the

perpetuity formula.

Case 2 (Constant Growth) Dividends grow at rate g, and the value of a common

stock with dividends growing at a constant rate is

Div1 Div1(1 g ) Div1(1 g )2 Div1(1 g )3 Div1

P0 (1-2)
1 R (1 R) 2
(1 R) 3
(1 R) 4 Rg

5
Where g is the growth rate. Div1 is the dividend on the stock at the end of the first period.

This is the formula for the present value of a growing perpetuity.

Case 3 (Differential Growth) In this case, an algebraic formula would be too

unwieldy. Stocks growing in this pattern should be valued case by case.

These three types of valuation models are based on the stock price definition. Usually

the parameters in the models are unrealistic to obtain in the real world. Therefore, there

are some alternative valuation methods that derive from the definition, which can be

easier to handle.

Stock price valuation models

Efficient Market Hypothesis

The efficient market hypothesis was first expressed by Louis Bachelier and emerged

as a prominent theoretic position in the mid-1960s. In general form, the hypothesis states

that the price of a security at time t fully reflects all the available information at time t-1.

The early literature on the efficient markets hypothesis was primarily concerned with

whether market participants can make any extranormal profits by taking advantage of the

information embedded in the market. The EMH theory was further developed by Eugene

Fama with his famous efficient capital markets review published in 1970. The majority of

early studies based on return-forecasting regressions provided empirical evidence in

support for the efficient markets model, and the dominance of the efficient markets model

in the literature continued until the late 1970s.

6
 Famas paper reviewed the theory and empirical work, and refined the theory by

giving definitions for three forms of market efficiency: weak, semi-strong and strong.

Weak

In this form, the information set is just historical prices.

Semi-strong

The concern of semi-strong form tests is whether prices efficiently adjust to other

information that is obviously publicly available (e.g. announcements of annual

earnings, stock splits, etc.) are considered.

Strong

Strong form tests concerned with whether given investors or groups have

monopolistic access to any information relevant for price formation.

Fama concluded from his tests that prices seem to efficiently adjust to obviously

publicly available information in weak and semi-strong form markets. Only limited

evidence against the hypothesis in the strong form tests, i.e., monopolistic access to

information about prices does not seem to be a prevalent phenomenon in the

investment community (Fama 1970).

According to the efficient market hypothesis, stock prices always fully reflect

available information. However, this definition is too general for any empirically

testable implications (Fama 1970). Fama listed three models developed by previous

studies, which specified the definition in more detail.

7
 Expected Return or Fair Game Model

The Fair Game Efficient Market Model rules out the possibility of excess return,

which is due to information reasons. The expected value of the difference between the

observed stock price and the expected value of the value that was projected at time t

on the basis of the available information set should be zero (Fama 1970).

The Submartingale Model

The Submartingale Model assumes that the expected value of period (t+1)s price,

as projected on the basis of the information set of time t, is equal to or greater than the

current price. If the expected returns and price changes are zero, then the price

sequence follows a martingale (Fama 1970).

The Random Walk Model

The Random Walk Model assumes that the current price of a security fully

reflects available information implies that successive price changes (or more usually,

successive one-period returns) are independent. In addition, successive changes (or

returns) are identically distributed.

Literature regarding the differences among these models was discussed in Famas

paper. In spite of different models of market efficiency, all that is required by the EMH is

that investors' reactions be random and follow a normal distribution pattern so that the net

effect on market prices cannot be reliably exploited to make an abnormal profit,

8
especially when considering transaction costs (including commissions and spreads). Thus,

everyone can be wrong about the market, but the market as a whole is always right.

Arguments concerning the validity of the EMH

Before the Efficient Market Hypothesis was introduced in the late 1960s, the

prevailing view was that markets were inefficient. Inefficiency was commonly believed

to exist in the United States and United Kingdom stock markets. Ever since the

introduction of Efficient Market Hypothesis, the arguments never stopped.

Some observers dispute the notion that markets behave consistently with the efficient

market hypothesis, especially in its stronger forms. Some economists, mathematicians

and market practitioners cannot believe that man-made markets are strong-form efficient

when there are prima facie reasons for inefficiency including the slow diffusion of

information, the relatively great power of some market participants (e.g. financial

institutions), and the existence of apparently sophisticated professional investors.

The way that markets react to surprising news is perhaps the most visible flaw in the

efficient market hypothesis. For example, news events such as surprise interest rate

changes from central banks are not instantaneously taken account of in stock prices but

rather cause sustained movement of prices over periods from hours to months.

Skeptics of EMH also argue that there exists a small number of investors who have

outperformed the market over long periods of time, in a way which is difficult to attribute

luck, including Peter Lynch, Warren Buffett, George Soros, and Bill Miller. These

investors' strategies are, to a large extent, based on identifying markets where prices do
9
not accurately reflect the available information, in direct contradiction to the efficient

market hypothesis which explicitly implies that no such opportunities exist.

The efficient market hypothesis also appears to be inconsistent with many events in

stock market history. For example, the stock market crash of 1987 saw the S&P 500 drop

more than 20% in the month of October despite the fact that no major news or events

occurred prior to the Monday of the crash, the decline seeming to have come from

nowhere. This would tend to indicate that rather irrational behavior can sweep stock

markets at random.

The relationship between stock return and market cap is also a challenge to the

efficient market hypothesis. Banz finds that average returns on small cap stocks are too

high, and the average returns on large cap stocks are too low (Banz 1981; Fama and

French 1992).

Variance Bounds Tests

Ever since the hypothesis of market efficiency was brought out, it has been one of the

most controversial areas in modern financial economics. Two influential studies by

Shiller (Shiller 1981a) and LeRoy and Porter (LeRoy and Porter 1981) were two pioneers

in challenging the efficient market hypothesis by the present value model of stock prices.

Both studies have demonstrated that stock prices are too volatile to be consistent with the

present value of rationally expected future dividends discounted by a constant real

interest rate (Yuhn 1996).

10
 Shiller used two data sets to compare the movements of the Pt*, which is regressed by

dividends, with the actual stock price Pt.. The two data sets contain annual observations

of the stock price indexes deflated by the Bureau of Labor Statistics wholesale price

index and the associated deflated dividends from both Standard and Poor Series and Dow

Jones Industrial Average Series. The results turned out that the volatility of stock price

appeared to be far too high five to thirteen times to be explained by the new

information about future real dividends. Therefore the efficient market hypothesis is not

reliable (Shiller 1981a).

These variance-bound tests compare the variance of actual stock price to an upper

bound, the variance of a function of actual dividends. Shiller's variance-bound inequality

is

(Pt ) (Pt*) (1-3)

Where () is the standard deviation, Pt is actual stock price, and Pt* is the ex post rational

stock price. The ex post rational stock price is the present discounted value of actual

dividends. Under the efficient markets model, actual stock price is the conditional

mathematical expectation of ex post rational price (Ackert and Smith 1993).

The LeRoy and Porter (1981) variance-bound tests are similar in spirit to Shiller's.

The tests differ, however, in that Shiller's test gives a simple point estimate and LeRoy

and Porter are able to attach significance levels. LeRoy and Porter also reject the model

but the rejections are not always statistically significant due to large confidence intervals.

11
 Debates on Variance Bounds Tests

The rejection of the PV model by Shiller (1981a) and LeRoy and Porter (1981) has

spawned great debates and controversies in the profession. Several subsequent studies

such as Flavin (1983), Kleidon ((Kleidon 1986) and Marsh and Merton (Marsh and

Merton 1986) have criticized the distributional assumptions maintained in the Shiller test.

Early volatility tests, including Shiller (1981a), LeRoy and Porter (1981) and Blanchard

and Watson ((Blanchard and Watson 1982), were based upon the assumption that stock

prices and dividends are trend-stationary. For example, Shiller (1981a) detrended stock

prices and dividends by dividing the series by the long-term growth rate. However, in

many situations simple detrending of time series does not warrant the stationarity of the

relevant variables. When time series have unit roots, but any allowance for stationarity is

not made, then sample means and variances are not consistent estimates of population

means and variances, therefore, it is invalid to use sample moments as estimates of

population moments. As Marsh and Merton (1986) argue, the Shiller inequality can even

be reversed depending on the time-series properties of the variables in the PV model.

Shiller (Shiller and Grossman 1981b), Kleidon (1986), Campbell and Shiller

(Campbell and Shiller 1987; Campbell and Shiller 1988), Perron ((Perron 1988) and

DeJong and Whiteman (DeJong, Whiteman et al. 1991), among others, have undertaken

formal tests for unit roots, and Kleidon (1986), Campbell and Shiller (1987), West (West

1988), and Mankiw (Mankiw, Romer et al. 1985) have developed second-generation

variance bounds tests which allow for the non-stationarity of stock prices and dividends.

However, even the second-generation variance bounds tests do not appear to have

12
resolved the volatility controversy. They produce conflicting evidence on stock price

volatility. For example, Kleidon (1986) provides no evidence of volatility whereas

Mankiw et al. (1985), West (1988a) and Campbell and Shiller (1987) confirm the

violation of variance inequalities, thus amplifying the confusion surrounding volatility

tests. Another criticism is that the second-generation variance bounds tests are highly

sensitive to the data-generating process for variables.

Flavin argued that in small samples the "volatility" or "variance-bounds" tests tend to

be strongly biased toward rejection of the null hypothesis of no excess volatility. Thus the

apparent violation of the market efficiency hypothesis may be reflecting the sampling

properties of the volatility measures in small samples rather than a failure of the market

efficiency hypothesis.(Flavin 1983)

Ackert and Smith argued that the results of variance-bound tests (Leroy and Porter

1981, Shiller 1981) depend on how cash distributions to shareholders are measured.

They found apparent evidence of excess volatility when a narrow definition of cash flow

(dividends only) is applied. They were unable to reject the hypothesis of market

efficiency when the cash flow measure also included share repurchases and takeover

distributions in addition to ordinary cash dividends (Ackert and Smith 1993). Based on

Ackert and Smiths study, operation cash flow may be able to smooth the volatility of

stock prices in the present value model.

13
Valuation Using Multiples

Valuation using multiples is a method for determining the current value of a company

(Wikipedia). To value a company, one can examine and compare the financial ratios of

relevant peer groups, multiply a ratio, or value driver, of the company by the

corresponding multiple. The multiples are usually based on the ratio of stock price to that

value driver for a group of comparable companies (Liu, Nissim et al. 2007).

The commonly used ratios include various measures of cash flow, book value,

earnings, and revenues, but earnings and cash flows are by far the most commonly used.

There is a common perception that operating cash flow is better than accounting earnings

in valuations. However, a recent study conducted by Liu, Nissin and Thomas suggested

that earnings dominated operating cash flows and dividends using U.S. market data (Liu,

Nissim et al. 2001; Liu, Nissim et al. 2002). This result also holds in international

markets according to a later paper by them (Liu, Nissim et al. 2007).

Cash Flow In Stock Price Valuation

Dividends VS Broader Cash Flow

According to Ackert and Smith (1993), narrowly defined cash flow in the variance

bounds tests leads to the rejection of efficient market hypothesis, and they proved that it

is unable to reject the hypothesis of market efficiency when using a broader cash flow

definition. Actually, within the finance literature, dividends include all cash distributions

to shareholders. For example, in the seminal work of Miller and Modigliani (Miller and

14
Modigliani 1961), cash distributed through share repurchases has the same economic role

as ordinary cash dividends (Ackert and Smith 1993).

Kleidon (1986) and Marsh and Merton (1986) discuss the problems that arise from

testing present value relations when ordinary dividends do not properly represent cash

flows. In addition, the smoothing of ordinary dividends Lintner (Lintner 1956), Fama and

Babiak (Fama and Babiak 1968) raises concerns because such behavior "implies changes

in a future residual dividend that do not show up in the currently observed dividend

series" (Kleidon (1986). Thus, tests which rely on a narrow definition of dividends may

incorrectly reject the present value relation (Ackert and Smith 1993).

The potential for problems, arising from a narrow definition of dividends, has

become more acute with the rapid growth of share repurchases and cash payments in

mergers and acquisitions. Shoven (1986) and Bagwell and Shoven (1989) show that in

recent years ordinary dividends represent less than half of the total cash distributed to

shareholders. These total cash flows are also more volatile than ordinary cash dividends

(Ackert and Smith 1993).

Cash Flow VS Earnings

Cash flow is an accounting term that refers to the amount of cash being received and

spent by a business during a defined period of time, sometimes tied to a specific project.

Operating cash flow, cash flow provided by operations or cash flow from operating

activities, refers to the amount of cash a company generates from the revenues it brings in,

15
excluding costs associated with long-term investment on capital items or investments in

securities.

Earnings represent the difference between revenues and charges, leading to a change

in net worth during a given period. Since the rationale behind the income statement is not

the same as for a cash flow statement, some cash flows do not appear on the income

statement. Likewise, some revenues and charges are not shown on the cash flow

statement (Vernimmen, Quiry et al. 2005).

Among all the previous studies, earnings have proved to have the greatest

explanatory power (Gallizo and Salvador 2006) to stock price volatility (Liu, Nissim et al.

2002; Liu, Nissim et al. 2007). However, some financial analysts argue that it is difficult

to compare earnings across firms because of the variety of methods used to calculate

accrual items, that managers can manipulate accruals to alter reported earnings, and that

accounting earnings can result in dysfunctional behavior since managers frequently select

projects based on earnings rather than discounted cash flows (Wilson and O'Brien 1986).

However, Liu, Nissim and Thomas (2007) argue that contrary to the common

perception that operating cash flows are better than accounting earnings at explaining

equity valuations, recent studies suggest that valuations derived from industry multiples

based on reported earnings are closer to traded prices than those based on reported

operating cash flows. The question addressed in the article is whether the balance tilts in

favor of cash flows when the following are considered: (1) forecasts rather than reported

numbers, (2) dividends rather than operating cash flows, (3) individual industries rather

16
than all industries combined, and (4) companies in non-U.S. markets. In all cases studied,

earnings dominated operating cash flows and dividends (Liu, Nissim et al. 2007) .

Liu, Nissim and Thomas believe that at a conceptual level, earnings should be the

more representative value driver because earnings reflect value changes regardless of

when the cash flows occur. Still, many practitioners, arguing that accruals involve

discretion and are often used to manipulate earnings, prefer to use cash flow multiples.

They also point out that expenses such as depreciation and amortization deviate

substantially from actual declines in value because they are based on ad hoc estimates

that are, in turn, derived from potentially meaningless historical costs (Liu, Nissim et al.

2007).

Other studies have also been done to compare the information content between

earnings and cash flows. Unfortunately, there is not a general agreement at this time.

Wilson concludes that for a given amount of earnings, the share market reacts more

favorably to cash flows than current accruals (Wilson 1987). However, Bernard and

Stober failed to generalize Wilsons finding to a larger period (Bernard and Stober 1989).

Summary of previous studies

From the discussion of previous studies, it can be assumed that a relationship between

stock price and cash flow exists. In the efficient market hypothesis model, if the market is

efficient, then the stock price is determined by the future dividends. Any change of stock

price is due to the new information regarding future dividends. Although the efficient

17
market hypothesis was challenged by some economists with the boundary test, which

asserts that the stock price is too volatile to be measured by the discounted present value

of future dividends, studies also show that the rejection of the present value model may

be because of the small sample size or the narrowly defined cash flow.

However, most of the previous studies focused on the S&P 500 or Dow Jones

Industrial Average indexes, which represent the large capitalization firms in

manufacturing industries. Although, in the study of Liu, Nissim and Thomas in 2007,

they conducted the industry-by-industry test to compare the performance of earnings and

operating cash flow. Liu, Nissim and Thomas exclude firms not covered by IBES,

typically with low and medium market capitalization, which casual theme restaurants

usually belong to. It is not focused on the study of casual theme restaurants; therefore, the

relation between the stock price and operating cash flow in casual theme restaurants is

necessary to contribute to the body of literature.

Part II Industry Context

In the following section, the relationship between stock price and cash flow will be

put in a new industry context, the hospitality industry, and the differences between

manufacturing industry and service industry as well as how these differences may affect

the sensitivity of that relationship will be addressed.

First, through the discussion of previous studies that focus on the relationship

between stock price and cash flow, it was found that all of them were conducted under a

18
cross-industries setting. However, the service industry is well-known for its unique

features, such as intangibility, simultaneity of production and consumption, customer

participation in the production and delivery of the service, heterogeneity, and perish

ability, which distinguish the service industry from the manufacturing industry. These

features create the underpinning need to explain the supply and demand relationship and

to help to differentiate them from manufacturing enterprises (Olsen, Tse et al. 2007).

In the manufacturing industry, the consumer products are most durable and demand

is reasonably constant and partially determined by the demographics existing in the

market at the time. These products are likely to be produced in economical quantities to

ensure that there will be sufficient numbers to meet the total demand. Items produced in

excess of current demand are usually inventoried to buffer against unexpected changes in

the demand curve and/or sold later. Seldom are these inventory items considered highly

perishable (Olsen, Tse et al. 2007) .

These features of the demand curve for manufacturing industries are seldom present

in the service industry. There are several reasons for this. First, it is difficult to

aggregate total demand in order to predict how many products will be sold by a service

provider over a specific planning period. The nature of the demand curve in the service

industry is local in nature. Second, finished products cannot be stored for much longer

than 15 minutes before they become unacceptable to the customer. The supply of

individual products produced in each unit must be sold almost immediately. Thus, the

demand curve can be said to be very temporal, fluctuating from hour to hour, day to day,

week to week, and month to month. It is not influenced as much by macro features such

19
as demographics but more by local economic conditions, local competition, and even

weather. As can be seen here, the demand curve for service businesses contains

characteristics not similarly found in the large scale consumer durable goods businesses

(Olsen, Tse et al. 2007).

Another point of difference between manufacturing and service has to do with the

management of inventory. As stated above, the total supply of products produced by

manufacturers can be inventoried if it is not sold immediately. Inventory is also created to

buffer firms from wide swings in the demand curve of the business. If finished products

remain too long in inventory, management can alter their prices in order to reduce

inventory. As was pointed out above, the products and services produced by service firms

such as those in the hospitality industry have little to no inventory life. If a restaurant

does not fill its supply of seats on any given day it can never sell them again (Olsen, Tse

et al. 2007). In other words, this inventory is highly perishable with almost no shelf life,

which determines that the restaurant industry is predominately a cash business, almost

without inventory. Therefore, whether the sensitivity of stock price to cash flow will hold

the same level for both cross-industries setting and service industry context is

questionable.

Second, most of previous research uses S&P 500 index data. However S&P 500

index usually represents the large cap firms in the manufacturing sector with a higher

average book-to-market ratio than the casual theme industry. Consequently, it is hard to

make a direct statement to an industry with small capitalization and low book-to-market

ratio from those studies.

20
 Therefore, it is necessary to study the relationship between stock price and operating

cash flow within the casual theme restaurants industry which can provide a better

understanding of operating cash flow for hospitality financial managers. In this thesis, the

relationship between stock price and operating cash flow will be tested using casual

theme restaurants data. A comparison of this relationship between Russell 3000 and

casual theme restaurants will also be conducted to examine the difference that may be

brought by the variation of operating cash flow, market capitalization and book-to-market

ratio.

Part III Propositions

It is obvious that the hospitality industry differs from the manufacturing industry

significantly in the demand curve and inventory management. As a consequence, the

relationship between stock price and cash flow in previous studies, which were conducted

in a cross-industries context, may not hold in hospitality. Here are the propositions in this

study (in the null):

1. We can expect there is no difference in the impact of cash flow on stock price

between large and small casual theme restaurants.

2. We can expect there is no difference in the impact of cash flow, earnings and

dividends on stock price between cross-industries and casual theme restaurant

samples.

21
 3. We can expect there is no difference in the impact of cash flow on stock price

between S&P 500 index and casual theme restaurants.

From this study, we expect stock price has a greater sensitivity to cash flow of casual

theme restaurants based on the nature of those companies.

Research questions and propositions will be discussed in detail in chapter three.

22
 Chapter Three

Methodology

The preceding chapters reviewed the literature and identified the objectives of this

study. This chapter provides the research propositions and research questions, the

introduction of data collection, and introduction of research models used for data analysis.

Part I Research Questions and Research Propositions

Research Questions:

As discussed in chapter two, almost all of the previous studies focused on the large

capitalization firms. However, most of the casual theme restaurants belong to the small

capitalization category. Then whether market capitalization will affect the impact of cash

flow on stock price in casual theme restaurants? Whats the difference in the impact of

cash flow on share price between large and small casual theme restaurants? Proposition 1

is presented based on these research questions.

Proposition 1: We can expect there is no difference in the impact of cash flow on stock

price between large and small casual theme restaurants.

Research Questions:

Cash flow, earnings and dividends are ranked in terms of explaining the stock price

volatility in previous studies with cross-industries setting. However, due to the

23
differences between manufacturing industry and service industry, whether the result will

hold in a casual theme restaurants setting? These questions bring out proposition 2.

Proposition 2: We can expect there is no difference in the impact of cash flow, earnings

and dividends on stock price between cross-industries and casual theme restaurant

samples.

Research Questions:

Due to the different nature of large capital manufacturing firms and small capital

service firms, whether the impact of cash flow on stock price in a broad market

capitalization index will hold in the casual theme restaurant is questionable. Previous

studies used S&P 500 index as sample set, which includes cross-industry firms with the

largest capitalization. This study tries to make clear the difference in the impact of cash

flow on stock price between S&P 500 index and casual theme restaurant firms. These

questions are followed by proposition 3.

Proposition 3: We can expect there is no difference in the impact of cash flow on stock

price between S&P 500 index and casual theme restaurants.

From the discussion in chapter two, these propositions seem to be plausible to me to

look at.

24
Part II Data Collection

In this part, an introduction of the data collection process will be provided. It includes

the dataset that the entire sample firms data came from, the standards used to define the

sample frame in that dataset, and the measurements and calculations of the variables.

Firm Selection

Sample firms used in this study are selected from casual theme restaurants following

three steps:

First, COMPUSTAT North America Industry Annual was chosen as the source

dataset. Two standards are used to select sample firms from the COMPUSTAT North

America Industry Annual database in this step:

North American Industrial Classification System (NAICS)

NAICS is a hierarchical structure and can consist of up to six digits/levels. The first

two digits of the structure designate the NAICS sectors that represent general categories

of economic activity. The third digit designates the subsector, the fourth digit designates

the industry group, the fifth digit designates the NAICS industry, and the sixth digit

designates the national industry.

Casual theme restaurants are under the classification Full Service Restaurants with

the NAICS code 722110.

25
 Industry Classification Code

The Industry Classification Code is a four-digit system of classification that identifies

a company's primary operation. SPC assigns these codes by analyzing the sales

breakdown from a company's 10K and annual report. The codes are based on the U.S.

SIC classification. The variable name of this code in COMPUSTAT dataset output is

DNUM.

Casual theme restaurants belong to the Eating Places with the DNUM=5812.

Therefore, the sample firms are selected from the COMPUSTAT North America

dataset with these two standards: NAICS=722110 and DNUM=5812.

Second, firm samples from the first step with annual data available from 1990 to 2005

are kept. Twenty firms are left after this step, which are shown in Appendix A.

Variables

Stock price

Stock price at the end of fiscal year is chosen in this study, which is DATA #1991 in

COMPUSTAT dataset.

Operating Cash Flow (OCF)

Operating cash flow here is defined as:

1
#* is the Data variable number in the COMPUSTAT.

26
 OCF = EBITDA (#13) total of interest expense (#15) tax expense (#16) net

change in working capital

Where net change in working capital is change in current assets (#4) change in cash

and cash equivalents (#1) change in current liabilities (#5) plus change in debt included

in current liabilities (#34).

Per share cash flow from operations (POCF)

Per share cash flow from operations is defined as OCF deflated by shares outstanding

(#25).

Net Income

Net income is defined as income before extraordinary itemsavailable for common

(#237).

Earnings Per Share (EPS)

Earnings Per Share is the data #58.

Dividends

Dividends for common (#21)

Part III Data Analysis

Value Drivers

27
 Three value drivers will be considered and compared in this study: Cash flow from

Operation, Earnings and dividends.

Multiple Valuation

The traditional multiple valuation method is followed, which requires that the price of

firm i (from the comparable group) in year t ( pit ) is directly proportional to the value

driver:

pit t xit it (2-1)

Where xit is the value driver for firm i in year t , t is the multiple on the value driver and

t is the pricing error.

To allow comparison of valuation errors for stocks of different values, the pricing

error can be deflated by the stock price (Liu, Nissim et al. 2007):

xit it
1 t (2-2)
pit pit

Multiples Construction

An industry multiple is constructed for each value driver of each company, based on

the prices and value drivers for all remaining companies in the sample set. In order to

avoid the targets valuation being contaminated by its own price, the target company is

deleted from the sample.

Based on the previous studies, harmonic mean of the ratio of price is chosen, which is

calculated by first finding the average value driver to price for the sample set and then

inverting that average (Liu, Nissim et al. 2007). Harmonic mean provides a way to
28
mitigate the effect of low value and reduce the impact on the multiple (Liu, Nissim et al.

2007).

For an illustration, assume there are five companies in the hospitality industry in the

U.S. in 1990, indexed by i =1,2,5, with earnings per share of $1.50,$3.00, $2.50, $0.50

and $2.00 and share prices of $20, $35, $45, $25 and $30, respectively. Assume that the

multiple that is relevant for company i = 3 is being calculated. If the average ratio of

price to EPS of the remaining four companies is chosen, the multiple will be:

1 20 35 25 30
Average P/E = ( ) 22.5 (2-3)
4 1.50 3.00 0.50 2.00
However, the harmonic mean P/E would be:

1
Harmonic mean P/E = 16.17 (2-4)
(1/ 4)[(1.50 / 20) (3.00 / 35) (0.50 / 25) (2.00 / 30)

As shown in the results, the harmonic mean method reduces the impact of company i

=4, which has a relative high P/E of 50, on the multiple.

Following this method, three multiples will be constructed:

1. P/E

Price to earnings ratio, the multiple of earnings

2. P/D

Price to dividend ratio, the multiple of dividends

3. P/C
Price to operating cash flow ratio, the multiple of operating cash flow

29
Analysis Procedure

Based on the previous description, 16-year data of 20 sample casual theme restaurants

will be processed in two steps: variables calculations and statistic analyses.

Step I Variables Calculations:

1. Dividends per share (#21) and share prices per share (#199) will be changed to

market value by multiplying the shares outstanding (#25).

2. Price to earnings ratio (P/E), price to dividend ratio (P/D) and price to operating

cash flow ratio (P/C) for each firm during each year will be calculated.

3. The industry multiples for earnings, dividend and operating cash flow will be

calculated following the methods stated above.

4. The pricing errors will be calculated following equation (3-2).

Step II Statistic Analyses

1. One-Way ANOVA

The One-Way ANOVA procedure produces a one-way analysis of variance for a

quantitative dependent variable by a single factor (independent) variable. Analysis of

variance is used to test the hypothesis that several means are equal. This technique is

an extension of the two-sample t test.

In addition to determining that differences exist among the means, it is necessary

to know which means differ. There are two types of tests for comparing means: a

30
priori contrasts and post hoc test. Contrasts are tests set up before running the

experiment, and post hoc tests are run after the experiment has been conducted.

For each group, number of cases, mean, standard deviation, standard error of the

mean, minimum, maximum, 95%-confidence interval for the mean, Levene's test for

homogeneity of variance, analysis-of-variance table and robust tests of the equality of

means for each dependent variable, user-specified a priori contrasts, and post hoc

range tests and multiple comparisons will be provided by the output.

One-Way ANOVA is chosen to analyze the differences of variances and means

among different market cap groups. This will be used to test proposition 1. The

sample set will be divided into three categories according to their market value:

Micro-Cap: Market value is equal to or is smaller than 250 million dollars.

Small-Cap: Market value is bigger than 250 million dollars and smaller than or

equal to 2000 million dollars.

Middle-Cap: Market value is bigger than 2000 million dollars.

The differences of variances and means of pricing errors of P/E, P/D and P/C

among these three groups will be compared with One-Way ANOVA.

2. Paired-Samples T Test

The Paired-Samples T Test procedure compares the means of two variables for a

single group. It computes the differences between values of the two variables for each

case and tests whether the average differs from zero.

31
 For each variable, mean, sample size, standard deviation, and standard error of the

mean will be provided in the output. For each pair of variables: correlation, average

difference in means, t test, standard deviation and standard error of the mean

difference and confidence interval for mean difference will be provided.

Paired-Sample T Test is chosen to test proposition two to compare whether the

pricing error means computed by P/E, P/D and P/C are different from each other.

3. One-Sample T Test

The One-Sample T Test procedure tests whether the mean of a single variable

differs from a specified constant.

One-Sample T Test is chosen for proposition 2. It will be used to test whether the

pricing errors of P/E, P/D and P/C are equal to zero.

Summary

Through the One-Way ANOVA, Paired-Samples T Test and One-Sample T Test,

three research questions will be answered.

32
 Chapter Four

Research Results

The basis for conducting multiple valuation tests within the casual theme restaurants

has been provided in the previous three chapters. In chapter one, the imperative of this

study has been discussed. Previous studies focused on the relationship between share

price and operating cash flow, and the rationale for using multiple valuation model were

all reviewed and discussed in chapter two. Chapter three has provided the detailed

methodologies to test the research questions in this study. In this chapter, the results of

these tests are presented in detail.

Results

Research Question One

As discussed in chapter two, almost all of the previous studies focused on the large

capitalization firms. However, most of the casual theme restaurants belong to a small

capitalization category. Then whether market capitalization will affect the impact of cash

flow on stock price in casual theme restaurants? Whats the difference in the impact of

cash flow on share price between large and small casual theme restaurants? Proposition 1

comes out based on these research questions.

Proposition 1: We can expect there is no difference in the impact of cash flow on stock

price between large and small casual theme restaurants.

In order to answer this question, the 320 firm-years samples are classified into three

categories:
33
 1. Micro-Cap: capitalization below $250 million. (Group 1, 194 firm-years)

2. Small-Cap: capitalization between $250 million and $2 billion. (Group 2, 113

firm-years)

3. Middle-Cap: capitalization between $2 billion and $10 billion. (Group 3, 13 firm-

years)

Then, One-Way ANOVA is chosen to test proposition one.

Table 4-1 Descriptive Statistics of Three Multiples by Groups

Group Number Minimum Maximum Mean Std. Deviation

2
PE 1 186 -14.010 2.234 -.19511 1.223644
2 113 -4.242 .114 .00726 .405787
3 13 .043 .062 .05087 .005891
3
PD 1 53 .000 15.646 .50426 2.261220
2 77 .001 2.025 .00726 .376280
3 6 .098 .931 .52603 .381207
4
PC 1 183 -.805 10.718 .63273 1.493107
2 111 .034 1.470 .18450 .209193
3 10 .101 .189 .14481 .033708

Table 4-1 shows the descriptive statistics of three multiples, classified by the market

capitalization into three groups.

2
Price to earnings ratio
3
Price to dividend ratio
4
Price to operating cash flow ratio

34
 Table 4-2 One-Way ANOVA Results for Proposition One

Sum of Mean
Squares df Square F Sig.
5
PRICE_ERROR_PE Between Groups 1578.274 2 789.137 .452 .637
Within Groups 539203.216 309 1744.994
Total 540781.490 311
6
PRICE_ERROR_PD Between Groups 79888.968 2 39944.484 7.216 .001
Within Groups 1666128.834 301 5535.312
Total 1746017.802 303
7
PRICE_ERROR_PC Between Groups 168.922 2 84.461 3.918 .021
Within Groups 6488.063 301 21.555
Total 6656.985 303

Table 4-2 shows the SPSS output of the One Way ANVOA. Dependent variables are

pricing errors for P/E (PRICE_ERROR_PE), pricing errors for P/D

(PRICE_ERROR_PD), pricing errors for P/C (PRICE_ERROR_PC), and the group

factor is market value (MARKET_CAP).

According to these results, it is comfortable to conclude that the variances of pricing

error of Price to Earnings ratio among different market cap groups are not significantly

different from each other at a 95% confidence level (.637>.05, it is failed to reject the

null hypothesis).

5
Pricing error of price to earnings ratio

6
Pricing error of price to dividend ratio

7
Pricing error of price to operating cash flow ratio

35
 However, the variances of pricing error of Price to Dividend and Price to Operating

Cash Flow among different market cap groups are significantly different from one other

at a 95% confidence level (.001<.05 and .021<.05).

These are the analyses regarding variances. The following output presents the

differences of means of different groups.

Table 4-3 Descriptives for Three Groups

Std. Std. 95% Confidence Interval

N Mean Deviation Error for Mean
Lower Upper
Bound Bound
PRICE_ERROR_PE 1 186 -6.0588 53.60099 3.93022 -13.8126 1.6950
2 113 -1.3888 8.22375 .77363 -2.9216 .1440
3 13 -2.3883 3.04781 .84531 -4.2301 -.5465
Total 312 -4.2145 41.69949 2.36077 -8.8596 .4306
PRICE_ERROR_PD 1 184 1.6349 12.48753 .92059 -.1815 3.4512
2 107 20.9967 99.15919 9.58608 1.9914 40.0020
3 13 74.9484 222.73720 61.77618 -59.6503 209.5472
Total 304 11.5849 75.91070 4.35378 3.0174 20.1523
PRICE_ERROR_PC 1 183 1.4060 5.84597 .43215 .5533 2.2586
2 111 -.0900 1.54464 .14661 -.3805 .2006
3 10 -.3753 .79622 .25179 -.9449 .1943
Total 304 .8012 4.68724 .26883 .2721 1.3302

According to the results in this output, regarding the pricing error of Price to Earnings

ratio, Small-Cap group has the lowest values of both mean (-1.3888) and the standard

error (.77363), followed by Middle-Cap (mean=-2.383, standard error=0.84531) and

Micro-Cap (mean=-6.0588, standard error=3.93022). Therefore, Price to Earnings is the

36
most powerful variable in explaining the variance of share price for Middle-Cap casual

theme restaurant firms.

However, as to the pricing error of Price to Dividend ratio, Micro-Cap has the lowest

values of both mean (1.6349) and standard error (.92059), followed by Small-Cap

(mean=20.9967, standard error=9.58608) and Middle-Cap (mean=74.9484, standard

error=61.77618). Therefore, price to dividend ratio is the most powerful value driver in

explaining the variance of share price for Micro-Cap casual theme restaurant firms.

The results of price to operating cash flow show that Small-Cap group has the lowest

values of both mean (-.0900) and standard error (.14661), followed by Middle-Cap group

(mean=-.3753, standard error=.25179) and Micro-Cap group (mean=1.4060, standard

error=.43215). Therefore, price to operating cash flow is the most powerful value driver

in explaining the variance of share price for Small-Cap causal theme restaurant firms.

Table 4-4 shows whether the equal variance assumption is satisfied for each value

driver. Table 4-5 presents the statistic results of mean difference tests.

Table 4-4 Test of Homogeneity of Variances

Levene Statistic df1 df2 Sig.

PRICE_ERROR_PE 2.466 2 309 .087
PRICE_ERROR_PD 24.659 2 301 .000
PRICE_ERROR_PC 7.514 2 301 .001

37
 Table 4-5 Multiple Comparisons for Three Groups

Dependent Variable (I)MARKET_CAP (J)MARKET_CAP Mean Difference (I-J) Std. Error Sig.
PRICE_ERROR_PE LSD 1 2 -4.66999 4.98238 .349
3 -3.67049 11.98382 .760
2 1 4.66999 4.98238 .349
3 .99950 12.23408 .935
3 1 3.67049 11.98382 .760
2 -.99950 12.23408 .935
Tamhane 1 2 -4.66999 4.00563 .570
3 -3.67049 4.02009 .741
2 1 4.66999 4.00563 .570
3 .99950 1.14588 .771
3 1 3.67049 4.02009 .741
2 -.99950 1.14588 .771
PRICE_ERROR_PD LSD 1 2 -19.36182(*) 9.04517 .033
3 -73.31354(*) 21.35126 .001
2 1 19.36182(*) 9.04517 .033
3 -53.95172(*) 21.85235 .014
3 1 73.31354(*) 21.35126 .001
2 53.95172(*) 21.85235 .014
Tamhane 1 2 -19.36182 9.63018 .134
3 -73.31354 61.78304 .592
2 1 19.36182 9.63018 .134
3 -53.95172 62.51552 .789
3 1 73.31354 61.78304 .592
2 53.95172 62.51552 .789
PRICE_ERROR_PC LSD 1 2 1.49591(*) .55855 .008
3 1.78125 1.50774 .238
2 1 -1.49591(*) .55855 .008
3 .28533 1.53287 .852
3 1 -1.78125 1.50774 .238
2 -.28533 1.53287 .852
Tamhane 1 2 1.49591(*) .45634 .004
3 1.78125(*) .50015 .002
2 1 -1.49591(*) .45634 .004
3 .28533 .29136 .715
3 1 -1.78125(*) .50015 .002
2 -.28533 .29136 .715

*The mean difference is significant at the .05 level.

According to the results from multiple comparisons, since the equal variance

assumption is not satisfied at a 95% confidence level (.087>.05), the Tamhane test is

chosen. Based on the p-value, all of the mean differences of price to earnings pricing

error are not significant at the 95% confidence level.

38
 As to the price to dividend ratio, the p-value of the Levene Statistic test is .000(<.05),

therefore, the equal variance assumption is satisfied. The LSD test should be chosen. It

can be concluded that the means are significantly different at the 95% confidence level

among three groups (.033<.05, .001<.05, .014<.05, the null hypothesis is rejected),

because group 3 has a significantly higher mean than group 2 and group 1.

Therefore, price to dividend has a different power in explaining the variance of share

price with different market capitalization of casual theme restaurant firms.

However, in the results of price to operating cash flow ratio, the p-value of Levene

Statistic is .001<.05, equal variance assumption is satisfied. The LSD test should be

chosen. Based on the p-value, the mean difference between group 1 and group 2 are

significantly different from each other (.008<.05, null hypothesis is rejected), because

group 1 has a significantly higher mean than group 2. However, the mean difference

between group 1 and group 3 and the mean difference between group 2 and group 3 are

not significantly different from each other (.238<.05, .852<.05, failed to rejected null

hypothesis).

In summary, to answer research question one, the operating cash flow has

significantly different impacts on the share price between Micro-Cap and Small-Cap

casual theme restaurant firms. The impact on the share price of Small-Cap is stronger

than on the share price of Micro-Cap casual theme restaurant firms.

39
 Research Question Two

Cash flow, earnings and dividends are ranked in terms of explaining the stock price

volatility in previous studies with cross-industries setting. However, due to the

differences between the manufacturing industry and the service industry, whether the

result will hold in a casual theme restaurants setting? These questions bring out

proposition 2.

Proposition 2: We can expect there is no difference in the impact of cash flow, earnings

and dividends on stock price between cross-industries and casual theme restaurant

samples.

To test this proposition, 320 firm-years samples are analyzed without differentiation

by market capitalization. Paired-Sample T Test and One-Sample T Test are chosen to

test proposition two.

Table 4-6 Paired Samples T Test

Paired Differences
t df Sig. (2-tailed)
Std. 95% Confidence Interval
Std. Error of the Difference
Mean Deviation Mean

Lower Upper
Pair PRICE_ERROR_PE -
-15.91361 87.09242 4.99509 -25.74307 -6.08414 -3.186 303 .002
1 PRICE_ERROR_PD
Pair PRICE_ERROR_PE -
-5.08652 43.44719 2.49187 -9.99008 -.18297 -2.041 303 .042
2 PRICE_ERROR_PC
Pair PRICE_ERROR_PD -
11.08204 77.14984 4.48424 2.25688 19.90720 2.471 295 .014
3 PRICE_ERROR_PC

From the results of Paired-Sample T Test, it is obvious that all the p-values are lower

than .05. Therefore, the null hypotheses are rejected. The mean differences between three

40
value drivers are significantly different from each other at the 95% confidence level.

Price to Dividend has a lowest mean difference (-5.08652) of pricing error, followed by

Price to Operating Cash Flow (11.08204) and Price to Earnings (15.91361).

Next, whether the means are different from zero are tested by One-Sample T Test.

Table 4-7 Descriptive Statistics of 320 Firms

N Minimum Maximum Mean Std. Deviation

PE 312 -14.010 2.234 -.11156 .979994
PD 136 .000 15.646 .38744 1.437199
PC 304 -.805 10.718 .45301 1.184934

Table 4-8 One-Sample Statistics

N Mean Std. Deviation Std. Error Mean

PRICE_ERROR_PE 312 -4.2145 41.69949 2.36077
PRICE_ERROR_PD 304 11.5849 75.91070 4.35378
PRICE_ERROR_PC 304 .8012 4.68724 .26883

According to the results, the pricing error of Price to Operating Cash Flow has the

lowest mean (.0812) and standard error mean(.26883), followed by pricing error of Price

to Earnings (mean=-4.2145, standard error mean=2.36077) and pricing error of Price to

Dividend (mean=11.5849, standard error 4.35378).

41
 Therefore, to answer research question two, cash flow has the strongest explanatory

power of the variance of share price of casual theme restaurant firms, followed by

earnings and dividend.

Research Question Three

Due to the different nature of large capital manufacturing firms and small capital

service firms, whether the impact of cash flow on stock price in a broad market

capitalization index will hold in casual theme restaurants is questionable. Previous studies

used S&P 500 index as sample set, which includes cross-industry firms with the largest

capitalization. This study tries to make clear the difference in the impact of cash flow on

stock price between S&P 500 index and casual theme restaurant firms. These questions

are followed by proposition 3.

Proposition 3: We can expect there is no difference in the impact of cash flow on stock

price between S&P 500 index and casual theme restaurants.

Table 4-9 Multiple Valuation Test Results for All 320 Firm-years Samples

Mean Median Std. Error Mean

PRICE_ERROR_PE -4.2145 -0.425 2.36077
PRICE_ERROR_PD 11.5849 -1.000 4.35378
PRICE_ERROR_PC .8012 -0.290 .26883

42
 Table 4-10 Results of Liu, Nissim and Thomas (2001)

Variables Mean Median Sd.

P/E -0.005 0.015 0.321

P/C -.0.042 0.150 0.989

In the study of Liu, Nissim and Thomas in 2002(Liu, Nissim et al. 2001; Liu, Nissim

et al. 2002), S&P 500 index has been chosen as a sample set. Their results showed that

earnings could be a better indicator than operating cash flow in the multiple valuation.

P/Es values were all lower than P/C in terms of mean, median and standard deviation, as

shown in Table 4-10.

However, in this study, with 320 firm-years casual theme restaurant samples, the

result came out differently from previous studies. P/C, the multiple of operating cash

flow has the lowest values in all of the three measures: mean, median and standard error.

Therefore, from this study, it can be concluded that operating cash flow has different

impacts on share price between casual theme restaurants and S&P 500 index samples.

Operating cash flow is more powerful in multiple valuation tests with casual theme

restaurant firms, which have relatively smaller market capitalizations.

43
 Chapter Five

Conclusions and Discussion

Chapter four has presented the results of the multiple valuation tests conducted under

the casual theme restaurants setting over the period of 1990 to 2005. This chapter

summarizes the results and presents the contribution, limitations and suggestions for

further study.

Summary of Results and Discussion

Research Question One

First, the operating cash flow has significantly different impacts on the share price

between Micro-Cap and Small-Cap casual theme restaurant firms. The impact on the

share price of Small-Cap is stronger than on the share price of Micro-Cap casual theme

restaurant firms.

Research Question Two

Second, the operating cash flow has the strongest explanatory power of the variance

of share price of casual theme restaurant firms, followed by earnings and dividend.

Research Three

Third, according to the results of this study, the operating cash flow has different

impacts on share price between casual theme restaurants and S&P 500 index samples.

44
Operating cash flow is more powerful in multiple valuation tests with casual theme

restaurant firms, which have relatively smaller market capitalizations.

Implications for Managers

Among all the general goals of management, increasing share prices and minimizing

the volatility of stocks could be one the most important task for managers, without

exception for casual theme restaurant managers.

Various studies have been conducted to provide managers with feasible and effective

indicators to explain the move of share prices. According to the results of previous

studies, earning has been proved to have the strongest power in explaining the variance of

share price. However, most of the previous studies that have focused on the relationship

between stock price and cash flow have used cross-industries data, primarily S&P 500

index. These studies do not distinguish service industry from manufacturing industry.

As we all know, the service industry is different from manufacturing in many ways,

such as intangibility, simultaneity of production and consumption, customer participation

in the production and delivery of the service, heterogeneity, and perish ability. These

features make the service industry different from the manufacturing industry in the

supply-demand relationship and the inventory management. The manufacturing firms

usually keep a large amount of inventory of raw materials as well as finished goods. And

they do a lot of credit buying and selling. However, the casual theme restaurant is

generally viewed as a cash business. They hardly keep finished goods in inventory,

45
neither a lot of raw materials, like the manufacturing industry usually does. This makes

cash take a dominant role on balance sheet, as well as in daily operations.

The results of this study provide a more specific guideline to casual theme restaurant

managers that operating cash flow is the best indicator to track share price, followed by

earnings and dividends. Stable share price can be achieved, to some extent, by smoothing

the operating cash flow stream.

Limitations

The fundamental limitation of this study would be the small sample size. In order to

gather enough available data information to carry on the analysis, non-public traded firms

are excluded from this study. Therefore, only 20 public-traded casual theme restaurants

are available with the data during the period of 1990 to 2005. Previous studies conducted

with cross-sectional data can have several hundred sample firms. This limitation might

lead the results of this study questionable. The statistical output of this study may be

different when conducted with a larger sample set.

A second limitation would be the small size (13) of the Middle-Cap category in the

analysis of research question one. Therefore, this group should be taken out from the

analysis in research question one. Actually, none of the results is significant regarding the

comparison between group 3 and the other two groups.

46
Suggestions for Further Studies

As stated above, small sample size is a fundamental limitation of this study. To obtain

a more general result, global sample set can be constructed, other than just limited to the

U.S. market. That would provide a much larger sample size.

47
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49
 Appendix A Sample Firms

GVKEY CONAME SMBL NAICS DNUM

1 2163 BENIHANA INC -CL A BNHNA 722110 5812
2 2282 BOB EVANS FARMS BOBE 722110 5812
3 3007 BRINKER INTL INC EAT 722110 5812
4 3424 STEAK N SHAKE CO SNS 722110 5812
5 3570 CBRL GROUP INC CBRL 722110 5812
6 4759 FLANIGANS ENTERPRISES INC BDL 722110 5812

7 4911 FRISCH'S RESTAURANTS INC FRS 722110 5812

8 7132 MAX & ERMAS RESTAURANTS MAXE 722110 5812
9 7566 RUBY TUESDAY INC RT 722110 5812
10 7696 NATHAN'S FAMOUS INC NATH 722110 5812
11 11538 J. ALEXANDER'S CORP JAX 722110 5812
12 11872 ARK RESTAURANTS CORP ARKR 722110 5812
13 13187 EACO CORP 3EACO 722110 5812
14 13188 CALA CORP CCAA 722110 5812
15 15092 CEC ENTERTAINMENT INC CEC 722110 5812
16 16665 APPLEBEES INTL INC APPB 722110 5812
17 19398 DENNYS CORP DENN 722110 5812
18 21153 SIXX HOLDINGS INC SIXX 722110 5812
19 22829 O'CHARLEY'S INC CHUX 722110 5812
20 24186 OSI RESTAURANT PARTNERS INC OSI 722110 5812

50
 Appendix B

Descriptive Statistics of Three Multiples by Groups

Group 1

N Minimum Maximum Mean Std. Deviation

PE_RE 186 -14.010 2.234 -.19511 1.223644
PD_RE 53 .000 15.646 .50426 2.261220
PC_RE 183 -.805 10.718 .63273 1.493107
Valid N (listwise) 52

Group 2

N Minimum Maximum Mean Std. Deviation

PE_RE 113 -4.242 .114 .00726 .405787
PD_RE 77 .001 2.025 .29624 .376280
PC_RE 111 .034 1.470 .18450 .209193
Valid N (listwise) 76

Group 3

N Minimum Maximum Mean Std. Deviation

PE_RE 312 -14.010 2.234 -.11156 .979994
PD_RE 136 .000 15.646 .38744 1.437199
PC_RE 304 -.805 10.718 .45301 1.184934
Valid N (listwise) 133

51
 Appendix C

SPSS Out Put for One-Way ANOVA for Proposition One

Des criptives

95% Conf idence Interval f or

Mean
N Mean Std. Deviation Std. Error Low er Bound Upper Bound Minimum Max imum
PRICE_ERROR_PE 1 186 -6.0588 53.60099 3.93022 -13.8126 1.6950 -666.47 75.19
2 113 -1.3888 8.22375 .77363 -2.9216 .1440 -84.09 12.32
3 13 -2.3883 3.04781 .84531 -4.2301 -.5465 -10.05 2.16
Total 312 -4.2145 41.69949 2.36077 -8.8596 .4306 -666.47 75.19
PRICE_ERROR_PD 1 184 1.6349 12.48753 .92059 -.1815 3.4512 -1.00 87.74
2 107 20.9967 99.15919 9.58608 1.9914 40.0020 -1.00 789.13
3 13 74.9484 222.73720 61.77618 -59.6503 209.5472 -1.00 798.43
Total 304 11.5849 75.91070 4.35378 3.0174 20.1523 -1.00 798.43
PRICE_ERROR_PC 1 183 1.4060 5.84597 .43215 .5533 2.2586 -4.99 55.48
2 111 -.0900 1.54464 .14661 -.3805 .2006 -.96 11.25
3 10 -.3753 .79622 .25179 -.9449 .1943 -.96 1.08
Total 304 .8012 4.68724 .26883 .2721 1.3302 -4.99 55.48

Tes t of Hom ogeneity of Var iances

Levene
Statistic df 1 df 2 Sig.
PRICE_ERROR_PE 2.466 2 309 .087
PRICE_ERROR_PD 24.659 2 301 .000
PRICE_ERROR_PC 7.514 2 301 .001

ANOVA

Sum of
Squares df Mean Square F Sig.
PRICE_ERROR_PE Betw een Groups 1578.274 2 789.137 .452 .637
Within Groups 539203.2 309 1744.994
Total 540781.5 311
PRICE_ERROR_PD Betw een Groups 79888.968 2 39944.484 7.216 .001
Within Groups 1666129 301 5535.312
Total 1746018 303
PRICE_ERROR_PC Betw een Groups 168.922 2 84.461 3.918 .021
Within Groups 6488.063 301 21.555
Total 6656.985 303

Post Hoc Tests

52
 Multiple Com parisons

Mean
Dif f erence 95% Conf idence Interval
Dependent Variable (I) MA RKET_CAP (J) MARKET_CA P (I-J) Std. Error Sig. Low er Bound Upper Bound
PRICE_ERROR_PE Tukey HSD 1.00 2.00 -4.66999 4.98238 .617 -16.4038 7.0638
3.00 -3.67049 11.98382 .950 -31.8932 24.5522
2.00 1.00 4.66999 4.98238 .617 -7.0638 16.4038
3.00 .99950 12.23408 .996 -27.8125 29.8115
3.00 1.00 3.67049 11.98382 .950 -24.5522 31.8932
2.00 -.99950 12.23408 .996 -29.8115 27.8125
LSD 1.00 2.00 -4.66999 4.98238 .349 -14.4737 5.1337
3.00 -3.67049 11.98382 .760 -27.2507 19.9097
2.00 1.00 4.66999 4.98238 .349 -5.1337 14.4737
3.00 .99950 12.23408 .935 -23.0731 25.0721
3.00 1.00 3.67049 11.98382 .760 -19.9097 27.2507
2.00 -.99950 12.23408 .935 -25.0721 23.0731
Tamhane 1.00 2.00 -4.66999 4.00563 .570 -14.3155 4.9755
3.00 -3.67049 4.02009 .741 -13.3521 6.0111
2.00 1.00 4.66999 4.00563 .570 -4.9755 14.3155
3.00 .99950 1.14588 .771 -1.8635 3.8625
3.00 1.00 3.67049 4.02009 .741 -6.0111 13.3521
2.00 -.99950 1.14588 .771 -3.8625 1.8635
PRICE_ERROR_PD Tukey HSD 1.00 2.00 -19.36182 9.04517 .084 -40.6665 1.9429
3.00 -73.31354* 21.35126 .002 -123.6036 -23.0235
2.00 1.00 19.36182 9.04517 .084 -1.9429 40.6665
3.00 -53.95172* 21.85235 .037 -105.4220 -2.4814
3.00 1.00 73.31354* 21.35126 .002 23.0235 123.6036
2.00 53.95172* 21.85235 .037 2.4814 105.4220
LSD 1.00 2.00 -19.36182* 9.04517 .033 -37.1616 -1.5620
3.00 -73.31354* 21.35126 .001 -115.3302 -31.2969
2.00 1.00 19.36182* 9.04517 .033 1.5620 37.1616
3.00 -53.95172* 21.85235 .014 -96.9544 -10.9490
3.00 1.00 73.31354* 21.35126 .001 31.2969 115.3302
2.00 53.95172* 21.85235 .014 10.9490 96.9544
Tamhane 1.00 2.00 -19.36182 9.63018 .134 -42.7183 3.9947
3.00 -73.31354 61.78304 .592 -244.4592 97.8321
2.00 1.00 19.36182 9.63018 .134 -3.9947 42.7183
3.00 -53.95172 62.51552 .789 -225.8787 117.9752
3.00 1.00 73.31354 61.78304 .592 -97.8321 244.4592
2.00 53.95172 62.51552 .789 -117.9752 225.8787
PRICE_ERROR_PC Tukey HSD 1.00 2.00 1.49591* .55855 .021 .1803 2.8115
3.00 1.78125 1.50774 .465 -1.7700 5.3325
2.00 1.00 -1.49591* .55855 .021 -2.8115 -.1803
3.00 .28533 1.53287 .981 -3.3251 3.8958
3.00 1.00 -1.78125 1.50774 .465 -5.3325 1.7700
2.00 -.28533 1.53287 .981 -3.8958 3.3251
LSD 1.00 2.00 1.49591* .55855 .008 .3968 2.5951
3.00 1.78125 1.50774 .238 -1.1858 4.7483
2.00 1.00 -1.49591* .55855 .008 -2.5951 -.3968
3.00 .28533 1.53287 .852 -2.7312 3.3018
3.00 1.00 -1.78125 1.50774 .238 -4.7483 1.1858
2.00 -.28533 1.53287 .852 -3.3018 2.7312
Tamhane 1.00 2.00 1.49591* .45634 .004 .3980 2.5938
3.00 1.78125* .50015 .002 .5663 2.9962
2.00 1.00 -1.49591* .45634 .004 -2.5938 -.3980
3.00 .28533 .29136 .715 -.4911 1.0618
3.00 1.00 -1.78125* .50015 .002 -2.9962 -.5663
2.00 -.28533 .29136 .715 -1.0618 .4911
*. The mean dif f erenc e is s ignif icant at the .05 level.

53
 Homogeneous Subsets
PRICE_ERROR_PE

Subs et
f or alpha
= .05
MARKET_CAP N 1
Tukey HSDa,b 1 186 -6.0588
3 13 -2.3883
2 113 -1.3888
Sig. .893
Means f or groups in homogeneous subsets are dis played.
a. Uses Harmonic Mean Sample Siz e = 32.913.
b. The group sizes are unequal. The harmonic mean
of the group s iz es is used. Type I error levels are
not guaranteed.

PRICE_ERROR_PC

Subs et
f or alpha
= .05
MARKET_CAP N 1
Tukey HSDa,b 3 10 -.3753
2 111 -.0900
1 183 1.4060
Sig. .348
Means f or groups in homogeneous subsets are dis played.
a. Uses Harmonic Mean Sample Siz e = 26.207.
b. The group sizes are unequal. The harmonic mean
of the group s iz es is used. Type I error levels are
not guaranteed.

54
 Appendix D
SPSS Output for Paired-Samples T Test

Paired Sam ples Statis tics

Std. Error
Mean N Std. Deviation Mean
Pair PRICE_ERROR_PE -4.3287 304 42.24033 2.42265
1 PRICE_ERROR_PD 11.5849 304 75.91070 4.35378
Pair PRICE_ERROR_PE -4.2854 304 42.24039 2.42265
2 PRICE_ERROR_PC .8012 304 4.68724 .26883
Pair PRICE_ERROR_PD 11.9180 296 76.90555 4.47004
3 PRICE_ERROR_PC .8360 296 4.74538 .27582

Paired Sam ples Corre lations

N Correlation Sig.
Pair PRICE_ERROR_PE &
304 -.006 .917
1 PRICE_ERROR_PD
Pair PRICE_ERROR_PE &
304 -.206 .000
2 PRICE_ERROR_PC
Pair PRICE_ERROR_PD &
296 -.021 .723
3 PRICE_ERROR_PC

Paired Sam ples Te st

Paired Dif ferences

95% Conf idence
Interval of the
Std. Error Dif f erence
Mean Std. Deviation Mean Low er Upper t df Sig. (2-tailed)
Pair PRICE_ERROR_PE -
-15.91361 87.09242 4.99509 -25.74307 -6.08414 -3.186 303 .002
1 PRICE_ERROR_PD
Pair PRICE_ERROR_PE -
-5.08652 43.44719 2.49187 -9.99008 -.18297 -2.041 303 .042
2 PRICE_ERROR_PC
Pair PRICE_ERROR_PD -
11.08204 77.14984 4.48424 2.25688 19.90720 2.471 295 .014
3 PRICE_ERROR_PC

55
 Appendix E
Descriptive Statistics of 320 Firms

N Minimum Maximum Mean Std. Deviation

PE 312 -14.010 2.234 -.11156 .979994
PD 136 .000 15.646 .38744 1.437199
PC 304 -.805 10.718 .45301 1.184934
Valid N (listwise) 133

56
 Appendix F
SPSS Output for One Sample T Test

One -Sam ple Statistics

Std. Error
N Mean Std. Deviation Mean
PRICE_ERROR_PE 312 -4.2145 41.69949 2.36077
PRICE_ERROR_PD 304 11.5849 75.91070 4.35378
PRICE_ERROR_PC 304 .8012 4.68724 .26883

One -Sam ple Tes t

Test Value = 0
95% Conf idence
Interval of the
Mean Dif f erence
t df Sig. (2-tailed) Dif f erence Low er Upper
PRICE_ERROR_PE -1.785 311 .075 -4.21449 -8.8596 .4306
PRICE_ERROR_PD 2.661 303 .008 11.58486 3.0174 20.1523
PRICE_ERROR_PC 2.980 303 .003 .80116 .2721 1.3302

57