2/19/2017 0 Comments
A nice article was published in The Financial Analysts Journal titled, Are Cash Flows Better Stock Return Predictors Than Profits? by Stephen Foerster, CFA, John Tsagarelis, CFA, and Grant Wang, CFA. I thought the research was insightful wanted to recap the findings here.
To summarize the conclusion of the article; cash flows are better predictors of stock returns than profits, meaning the statement of cash flows is more useful to forecast returns than the income statement. Furthermore, the cash flow statement constructed using the direct method, as opposed to the conventional indirect method, offers additional explanatory value.
To explain the analysis, the authors provided an example of a statement of cash flows using the direct method and compared this to the indirect method.
The cash flow from operations, using the indirect method, is broken down into more detail when the cash flow statement is constructed via the direct method. Subcategories of operating cash flows using the direct method are: direct business, financing, tax, and one-time items (not shown in example above). This breakdown of operating cash flows allows for an easy elimination one-time items. The authors conclude the more detailed breakdown of operating cash flows offers additional explanatory value of future stock returns not available from the indirect statement of cash flows or the income statement. Definitely worth a read for those who like getting into the details.
Michael Grove, CFA