This paper models firms’ choices between alternative means of presenting information, and the effects of different presentations on market prices when investors have limited attention and processing power. In a market equilibrium with partially attentive investors, we examine the effects of alternative: levels of discretion in pro forma earnings disclosure, methods of accounting for employee option compensation, and degrees of aggregation in reporting. We derive empirical implications relating pro forma adjustments, option compensation, the growth, persistence, and informativeness of earnings, short-run managerial incentives, and other firm characteristics to stock price reactions, misvaluation, long-run abnormal returns, and corporate decisions.

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.