Cash Flows, Earnings Quality, & Stock Returns

One of my original purposes in starting my blog was to create a place to keep track of things I came across on the Web that might be useful in my classes. I just found another one: "Cash Flow Is King: Cognitive Errors by Investors" by Todd Houge of U of Iowa and Tim Loughran of Notre Dame. Here's the abstract:

When investors fixate on current earnings, they commit a cognitive error and fail to fully value the information contained in accruals and cash flows. Extending the accrual anomaly documented by Sloan [1996], we identify significant excess returns from a cash flow-based trading strategy. The market consistently underestimates the transitory nature of accruals and the long-term persistence of cash flows. We find that the accrual anomaly derives from the poor performance of high accrual firms, which are more likely to manage earnings. Combining the accrual and cash flow information also reveals that investors misvalue the quality of earnings. Contrary to Fama [1998], these anomalies are robust to the three-factor model with equally or value-weighted portfolio returns.

Houge and Loughran find that markets undervalue firms with high operating cash flows to asset ratios and overvalue those with low cash flow/asset ratios. Somewhat surprisingly, Cash Flow/Assets is negatively correlated with Book/Market ratios (i.e. a firm with low CF/Assets is likely to also be a high Book/Market firm), so this is not just another way of capturing the value anomaly. They also find that the negative returns for high accrual firms are mostly evident among firms with the highest accruals.

But the really interesting finding in the paper has to do with earnings quality. The high cash flows/low earnings combination (basically, low accruals) indicates high earnings quality, while low cash flows and high earnings (high accruals) proxies for low earnings quality. When they compare returns to high cash flow/low earnings firms to those with low cash flows and high earnings, the high CF/low earnings firms outperform their opposite numbers by almost 16% per year on a risk adjusted basis. Not too shabby.

The paper was published in the Journal of Psychology and Financial Markets in 2000, but you can get an ungated version here.

Comments

[BxCapricorn:]

I would keep in mind that this paper was written in 2000, and although as you pointed out, the paper shows that companies with high cash flow-to-earnings ratios, outperform others by 16%, the market is different now. We are in a long term bear market, as massive amounts of money de-leverages and Bernanke carefully allows US demand destruction to off-set inflationary pressures. There is very little economic or investment history to study and apply to our current situation. I expect to see many money managers continue to apply previously trusted methods of stock valuation (i.e. Bill Miller, Pabrai Mohnish, Eddie Lambert, Kirk Kerkorian, Carl Icahn) and continue to fail miserably. You may be onto something by focusing on FCF being "key" to surviving in a tight credit environment. While the previously mentioned "gurus" plow vast fortunes into "value traps", the wise investor may look for a new paradigm based on FCF related variables.

2008 Jul 06 12:34 PM

[E.D.Hart:]

anybody know of a screen for this methodology?

2008 Jul 06 04:25 PM

[bill9300:]

You should alway try to determine the quality of the Operating or Free Cash Flow, in some cases the increase in the Cash Flow is due to streching out the payment of A/Ps (which is poor quality Cash Flow).


Check out this article- on Amazon's Free Cash Flow and how an GS's analyst put a 20 times multiple on it to justify a valuation.


www.istockanalyst.com/...~title_Amazon---Is-~qu...

2008 Jul 07 06:24 PM

[bill9300:]

sorry the above link on the quality of the cash flow, or FCF did not work. another try-

www.istockanalyst.com/...~title_Amazon---Is-~qu...

2008 Jul 07 06:32 PM

[bill9300:]

3rd try to post link, on the quality of Free Cash Flow.

seekingalpha.com/artic...

2008 Jul 07 06:42 PM

[dilettantedude:]

first of all, anyone who values a stock based on quarterly, instead of estimated annual, FCF is an idiot. accruals vary greatly from quarter to quarter, and more so in seasonal companies. quarterly numbers contain a great deal of noise and little information, other than maybe being positive.

the FCF methodology makes sense from another viewpoint, also. wall street, and most other analysts, focus on EPS. because they do, that's what public companies manage. wall street does not focus on FCF, so it's a fairer representation of the true profitability of a company. all you have to do to see this is to graph FCF and EPS over several years. you can lay a ruler along the EPS bars, while the FCF bars jump all over the place.

nevertheless, a company with FCF/share consistently higher than EPS is almost by definiton being undervalued. it doesn't necessarily mean it's cheap, but clearly if real money/share is greater than manipulated EPS, and real money thus gets a lower multiple than "wall street money," something's wrong somewhere.

2008 Jul 07 11:25 PM