When Cash Flow is King
What is the best predictor of stock returns?
October 22, 2014
When it comes to assessing the intrinsic equity value of a company, the income statement has always been a major part of the analysis. But according to new research, there is a much better measure for predicting profitability – cash flows. A trio of researchers – Stephen Foerster, John Tsagarelis, and Grant Wang – has found that, based on a 1994-2013 sample of S&P 1500 stocks, cash flow measures prove to be even better predictors of stock returns than various income statement-based measures.
In their paper, “Are Cash Flows Better Stock Return Predictors Than Profits”, the authors present a way to transform indirect cash flow method statements into more direct estimates of cash flows from operations and other sources.Through this method, they find that stocks in the highest cash flow decile outperform those in the lowest cash flow decile by over 10% annually after controlling for well-known risk factors.
The bottom line for investors: it’s better to look beyond the income statement to other measures, like cash flow, that can better predict value.
We then derive ‘direct method’ cash flow measures and form portfolio deciles based on these measures. Stocks in the highest cash flow decile outperform those in the lowest cash flow decile by over 10% annually after controlling for well-known risk factors. Our results are robust to the investment horizon, and controlling for sector differences. We also show that, in addition to operating cash flow information, cash taxes and capital expenditures provide incremental predictive power.
Download the paper here.