Thread by @DantonQu

Are Cash Flows Better Stock Return Predictors Than Profits?

"GAAP permit too many types of financial statement presentations;
information is too aggregated and inconsistently presented,
difficult for users to understand the relationship between how accounting information is presented and the underlying economic results of the company."

"The farther down the income statement one goes, the more “polluted” profitability measures become and the less related to “true” or economic profitability. Yet it is not obvious that any accrual accounting profit measure, should be superior to cashbased measures"

"Our study shows that by using a standardized “direct cash flow” template, investors can better understand a company’s historical, contemporaneous,
and forecasted return potential."

"In this article, we highlight how investors can potentially achieve superior incremental risk-adjusted returns by replacing commonly used profitability ratios—including return on equity and price–earnings multiples—with their cash flow equivalents."

"Our main finding is that direct cash flow measures are generally better stock return predictors than indirect cash flow measures, which in turn tend to be better than various income statement profitability measures that focus on gross profits, operating profits, or net income."

results:
additional information in segregating cash flow components for predicting the cross section of returns.
in addition to the information contained in cash flows from operations, there is incremental information in disaggregating tax activities and capex.

Companies that generate strong cash flows from operations while paying relatively low cash taxes and having relatively less capital expenditure tend to perform best.

Return and Yield Measures and One-Month-Ahead Returns, October 1994–December 2013:
Our results (with market value of equity in the denominator of our measures) suggest a robustness of the superiority of cash flow measures compared with profitability measures.

"we found no consistent pattern across all sectors but can summarize our results as follows."

"we showed that commonly used income statement–related metrics, including
return on assets and earnings yield, have some predictive power, but in general, cash-based measures are superior to measures of operating profitability and gross profitability to total assets."

"We created a direct CF template by segregating operating CFs from financing, tax, nonoperating, and investing activites. We argue that this segregation helps investors understand how value is created and thus better estimate the true intrinsic value (sic) of a company’s equity."