Investors are always on the lookout for the most profitable companies – but what if profits aren’t the best indicator of future stock performance? A new paper being presented at the 2015 Northern Finance Association Conference (September 18-20) finds that cash flows trump profits when it comes to picking top performers. The paper, “Are Cash Flows Better Stock Return Predictors Than Profits,” was written by Stephen Foerster, Ivey Business School, Western University along with John Tsagarelis and Grant Wang, both from Highstreet Asset Management Inc.
The authors find that many of the measures that investors traditionally rely on are actually poor predictors of future performance, including return on assets and earnings yields. Instead, cash-based measures are superior to operating profitability and gross profitability-to-total asset measures. Specifically, the authors find that through a direct cash flow method, investors can understand how value is being created and derive a better estimate of the true intrinsic value of the firm’s equity.
The authors’ findings support recent initiatives by both the International Accounting Standards Board and the U.S. Financial Accounting Standards Board to require reconstructed financial statements. For investors, this provides a means of uncovering important information about a company’s future prospects.