Are Cash Flows Better Stock Return Predictors than Profits?

Abstract

Although various income statement–based measures predict the cross section of stock returns, direct method cash flow measures have even stronger predictive power. We transform indirect method cash flow statements into disaggregated and more direct estimates of cash flows from operations and other sources and form portfolios on the basis of these measures. Stocks in the highest-cash-flow decile outperform those in the lowest by over 10% annually (risk adjusted). Our results are robust to investment horizons and across risk factors and sector controls. We also show that, in addition to operating cash flow information, cash taxes and capital expenditures provide incremental predictive power.

Keywords: direct cash flow method, cash flows, profitability, stock return predictability, free cash flow yields, cash flow return on invested capital

JEL Classification: G10, G14