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Are Cash Flows Better Stock Return Predictors than Profits?

46 Pages Posted: 28 Jul 2014 Last revised: 25 May 2017

Stephen R. Foerster

University of Western Ontario - Richard Ivey School of Business

John Tsagarelis

Primes Corporation

Grant Wang

Highstreet Asset Management

Date Written: January 5, 2017

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

Suggested Citation

Foerster , Stephen R. and Tsagarelis, John and Wang, Grant, Are Cash Flows Better Stock Return Predictors than Profits? (January 5, 2017). Financial Analysts Journal, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2472571 or http://dx.doi.org/10.2139/ssrn.2472571

Stephen Foerster (Contact Author)

University of Western Ontario - Richard Ivey School of Business ( email )

1255 Western Road
London, Ontario N6G 0N1
Canada
519-661-3726 (Phone)
519-661-3485 (Fax)

John Tsagarelis

Primes Corporation ( email )

United States

Grant Wang

Highstreet Asset Management ( email )

244 Pall Mall Street
London, Ontario N6A 5P6
Canada

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