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When cumulative net operating income (accounting value-added) outstrips cumulative free cash flow (cash value-added), subsequent earnings growth is weak. If investors with limited attention focus on accounting profitability, and neglect information about cash profitability, then net operating assets, the cumulative difference between operating income and free cash flow, measures the extent to which reporting outcomes provoke over-optimism. During the 1964–2002 sample period, net operating assets scaled by total assets is a strong negative predictor of long-run stock returns. Predictability is robust with respect to an extensive set of controls and testing methods.

Information is vast, and attention limited. People therefore simplify their judgments and decisions by using rules of thumb, and by processing only subsets of available information. Experimental psychologists and accountants document that individuals, including investors and financial professionals, concentrate on a few salient stimuli (see e.g., the surveys of Fiske and Taylor (1991) and Libby et al. (2002)). Doing so is a cognitively frugal way of making good, though suboptimal decisions. An investor who values a firm based on its earnings performance rather than performing a complete analysis of financial variables is following such a strategy. Several authors have argued that limited investor attention and processing power cause systematic errors that affect market prices.1 Systematic errors may derive from a failure to think through the implications of accounting rule changes or earnings management. However, even if accounting rules and firms’ discretionary accounting choices are held fixed, some operating/reporting outcomes highlight positive or negative aspects of performance more than others. In this paper, we propose that the level of net operating assets—defined as the difference on the balance sheet between all operating assets and all operating liabilities—measures the extent to which operating/reporting outcomes provoke excessive investor optimism. We will argue that the financial position of a firm with high net operating assets is less attractive than superficial appearances suggest. In other words, we argue that a high level of net operating assets, scaled to control for firm size, indicates a lack of sustainability of recent earnings performance, and that investors do not fully discount for this fact. A basic accounting identity states that a firm's net operating assets are equal to the cumulation over time of the difference between net operating income and free cash flow (see Penman (2004, p. 230) for the identity in change form): equation(1) NetOperatingAssetsT=∑0TOperatingIncomet-∑0TFreeCashFlowt. Turn MathJax on Thus, net operating assets are a cumulative measure of the deviation between accounting value added and cash value added—‘balance sheet bloat’. An accumulation of accounting earnings without a commensurate accumulation of free cash flows raises doubts about future profitability. In fact, we document that high normalized net operating assets (indicating relative weakness of cumulative free cash flow relative to cumulative earnings) is associated with a rising trend in earnings that is not subsequently sustained. Furthermore, as argued in more detail in Section 2, high net operating assets may provide a warning signal about the profitability of investment. If investors have limited attention and fail to discount for the unsustainability of earnings growth, then firms with high net operating assets will be overvalued relative to those with low net operating assets. In the long run, as public information arrives such mispricing will on average be corrected. This implies that firms with high net operating assets will on average earn negative long-run abnormal returns, and those with low net operating assets will earn positive long-run abnormal returns. To understand the determinants of investor perceptions in greater depth, we can alternatively decompose net operating assets as follows. Since free cash flow is the difference between cash flow from operations and investment, we obtain: equation(2) NetOperatingAssetsT=∑0TOperatingIncomet-∑0T(OperatingCashFlowt-Investmentt)=∑0T(OperatingIncomeBeforeDepreciationt-OperatingCashFlowt)+∑0T(Investmentt-Depreciationt). Turn MathJax on Eq. (2) indicates that net operating assets is the sum of two cumulative differences between accounting and cash value added: (Operating Income Before Depreciation-OperatingDepreciation-Operating Cash Flow), and (Investment-Depreciation)(Investment-Depreciation). Thus, firms with high net operating assets have high cumulative deviation between accounting and cash profitability derived from both operating and investing activities. Simplifying (2) yields equation(3) NetOperatingAssetsT=∑0TOperatingAccrualst+∑0TInvestmentt, Turn MathJax on which expresses net operating assets as the sum of cumulative operating accruals, and cumulative investment. Two simple examples illustrate how a transaction can increase accounting profitability relative to cash basis profitability, contributing to balance sheet bloat (Section 2 describes the range of possible cases more fully). First, when a firm books a sale as a receivable before it has received the actual cash inflow, its net operating assets increase. Second, when a firm records an expenditure as an investment rather than an expense, its net operating assets increase. In both these cases, current accounting profitability may not be sustained in the future, so investors who focus on accounting income may overvalue the firm. A possible reason why high net operating assets may be followed by disappointment is that the high level is a result of an extended pattern of earnings management that must soon be reversed; see Barton and Simko (2002).2 Alternatively, even if firms do not deliberately manage investor perceptions, investors with limited attention may fail to make full use of available accounting information. Thus, the interpretation of net operating assets that we provide in this paper accommodates, but does not require, earnings management.3 Net operating assets can provide a more complete proxy for investor misperceptions than the measures used in past literature for two reasons. First, net operating assets by definition consist of the deviations between cash and accounting profitability, rather than merely being correlated with these deviations.4 Second, under our hypothesis, flow variables such as accruals provide only a fragmentary indicator of the degree to which operating/reporting outcomes provoke excessive investor optimism. As Eqs. (1) and (2) indicate, net operating assets reflect the full history of flows. If investors with limited attention do not make full use of balance sheet information, then net operating assets is potentially a more comprehensive return predictor than the single-period slices considered in past literature.5 Alternative measures of accruals, a flow variable, have been found to have different explanatory power for returns (see, e.g., Collins and Hribar, 2002; Teoh et al., 1998a and Teoh et al., 1998b; Thomas and Zhang, 2002). Richardson et al. (2003) and Fairfield et al. (2003) report evidence of one-year-ahead stock return predictability based upon the most recent period operating and investing accruals. We document here that the level of normalized net operating assets has greater power, over a longer horizon, to predict returns than the associated flow variables. To test for investor misperceptions of firms with bloated balance sheets, we measure stock returns subsequent to the reporting of net operating assets. The level of net operating assets scaled by beginning total assets (hereafter NOA) is a strong and robust negative predictor of future stock returns for at least three years after balance sheet information is released. We call this the sustainability effect, because high NOA is an indicator that past accounting performance has been good but that equally good performance is unlikely to be sustained in the future; and that investors with limited attention will overestimate the sustainability of accounting performance. A trading strategy based upon buying the lowest NOA decile and selling short the highest NOA decile is profitable in 35 out of the 38 years in the sample, and averages equally-weighted monthly abnormal returns of 1.24%, 0.83% and 0.57%, all highly significant, both economically and statistically, in the first, second and third year, respectively, after the release of the balance sheet information. The effect remains strong with value weights, and further adjustments using factor models. The Sharpe ratio for an equally weighted trading strategy based on the extreme NOA deciles and characteristic-adjusted returns in year t+1t+1, for example, is 1.66, indicating a reward to risk ratio that is very attractive relative to holding the stock market as a whole. The effect also remains strong after including various past return measures and current-period operating accruals in Fama and MacBeth (1973) cross-sectional regressions. The coefficient on NOA is highly statistically and economically significant, indicating that the sustainability effect is distinct from the size and book market effects (Fama and French, 1992), the monthly contrarian effect (Jegadeesh, 1990), the momentum effect (Jegadeesh and Titman, 1993), the long-run winner/loser effect (DeBondt and Thaler, 1985), and the accruals anomaly (Sloan, 1996). In addition, since book-to-market and past returns are measures of past and prospective growth, these controls suggest that the findings are not a risk premium effect associated with the firm's growth rate. Since operating and financing sides of the balance sheet are equal, net operating assets equal the sum of net external financing via equity and net financial obligations (debt-cash)(debt-cash). In a multiple regression, we find that the financing correlates of NOA—scaled equity, debt, and (the negative of) cash—also significantly predict future returns with roughly comparable coefficients. Thus, the predictive power of NOA is related not just to cumulative net equity and debt financing, but to whether this new financing is invested or is accumulated as greater cash holdings. Furthermore, the ability of NOA to predict returns is robust with respect to the scaling variable, and to eliminating from the sample firms with recent equity issuance or M&A activity exceeding 10% of total assets. Thus, the sustainability effect is subsumed by neither the new issues puzzle of Loughran and Ritter (1995), nor by M&A-related effects. The evidence from the negative relation between NOA and subsequent returns suggests that investors do not optimally use the information contained in NOA to assess the sustainability of performance. Abel and Mishkin (1983) test that includes accruals, cash flows, and NOA as forecasting variables of future earnings and returns is consistent with investor overoptimism about the earnings prospects of high-NOA firms. Further tests indicate that NOA remains a strong return predictor after additionally controlling for the sum of the last three years’ operating accruals, and the latest change in NOA. These findings suggest that NOA provides a cumulative measure of investor misperceptions about the sustainability of financial performance that captures information beyond that contained in flow variables such as operating accruals or the latest change in NOA. Finally, we find that the sustainability effect has continued to be strong during the most recent 5 years. The sustainability effect was strongest in 1999 coinciding with the recent boom market, and the predictive power of NOA is robust to the exclusion of this year. The predictive effect of NOA remained strong even during the market downturn in 2000. Thus, it seems that arbitrageurs were not, in the sample period, fully alerted to NOA as a return predictor.

If investors have limited attention, then accounting outcomes that saliently highlight positive aspects of a firm’s performance will encourage higher market valuations. When cumulative accounting value added (net operating income) over time outstrips cumulative cash value added (free cash flow), we argue that it becomes hard for the firm to sustain further earnings growth. We further argue that investors with limited attention tend to overvalue firm whose balance sheets are ‘bloated’ in this fashion. Similarly, investors tend to undervalue firms when accounting value added falls short of cash value added. The level of net operating assets, which is the difference between cumulative earnings and cumulative free cash flow over time, is therefore a measure of the extent to which operating/reporting outcomes provoke excessive investor optimism. As such, net operating assets should negatively predict subsequent stock returns. This argument allows for the possibility of earnings management, but does not require it. In our 1964–2002 sample, net operating assets do contain important information about the long-term sustainability of the firm’s financial performance. Firms with high net operating assets normalized by beginning total assets (NOA) have high and growing earnings prior to the conditioning date, but declining earnings subsequent to that date. Furthermore, NOA is a strong and highly robust negative predictor of abnormal stock returns for at least three years after NOA is measured. These findings are both statistically and economically significant. This evidence suggests that market prices do not fully reflect the information contained in NOA for future financial performance. We call this phenomenon the sustainability effect. The predictive power of NOA remains strong after controlling for a wide range of known return predictors and asset pricing controls. NOA has stronger and more persistent predictive power than flow components of NOA such as operating accruals or the latest change in NOA. This evidence suggests that there is a cumulative effect on investor misperceptions of discrepancies between accounting and cash value added. Net operating assets therefore provide a parsimonious balance sheet measure of the degree to which investors overestimate the sustainability of accounting performance. An important scientific and policy issue in accounting is how extensively and effectively investors use different kinds of reported accounting information. Our findings indicate that the balance sheet contains information above and beyond that contained in the income statement that is useful for evaluating the financial prospects of the firm. Furthermore, our evidence indicate that investors do not make full use of this balance sheet information. These findings suggest that firms, the business media and policymakers should consider possible ways to make balance sheet information more salient and transparent to investors. ARTICLE IN PRESS 328 D. Hirshleifer et al. / Journal of Accounting and Economics 38 (2004) 297–331 A previous literature has documented that balance sheet ratios can be used to predict future stock returns.25 This literature develops weighting schemes that combine various ratios to maximize predictive power, presumably by sweeping together a mixture of economic sources of predictability. In the absence of a prior conceptual framework for determining optimal weights, it is not clear whether the weights will remain stable across samples and time periods. A distinctive feature of this paper is that we employ a simple and parsimonious aggregate balance sheet measure, net operating assets, whose predictive power is motivated by a very simple psychological hypothesis. This hypothesis is that investors have limited attention; that they allocate this attention to an important indicator of value added, historical earnings; and that this comes at the cost of neglecting the incremental information contained in cash flow measures of value added.