Cash Flow Still King to Us
We are firm believers that analysts should look for discrepancies between earnings and cash flow as one of the key criteria for identifying inferior/superior return candidates. Does a recent academic paper making the rounds shake our faith?
Abstract:
Contrary to the common perception that operating cash flows are better than accounting earnings at explaining equity valuations, recent studies suggest that valuations derived from industry multiples based on reported earnings are closer to traded prices than those based on reported operating cash flows. We extend those analyses to determine if the balance tilts in favor of cash flows when we consider a) forecasts rather than reported numbers, b) dividends rather than operating cash flows, c) individual industries rather than all industries combined, and d) firms in other markets beyond the U.S. Our main finding is that in all venues cash flows (both operating and dividends) are dominated by earnings. Our results imply that those seeking quick valuations should use multiples based on forecasted earnings, since they are remarkably close to traded prices.
Liu, Jing, Thomas, Jacob K. Kandathil and Nissim, Doron, “Cash Flow is King? Comparing Valuations Based on Cash Flow Versus Earnings Multiples” (August 25, 2006). Available at SSRN: http://ssrn.com/abstract=926428
The last sentence pretty much says it all. Multiples based on forecasted earnings… are remarkably close to traded prices. What this tells us is not that earnings are superior to cash flow. Rather, earnings themselves are hardly any better than the current share price in determining a company’s current valuation. Why shouldn’t those seeking quick valuations simply look at the price itself, since it will be remarkably close to the multiple based on forecasted earnings, and must surely be easier to determine.
Valuation is one thing. Value is quite another. We’ll stick with cash flow to find value.
