For investors, the purpose of financial accounting is to provide an accurate representation of a company’s current business condition, as well as its future prospects. A seemingly eternal question is whether a company’s cash flows or earnings are better at predicting the future performance of a company’s stock price. Several Investing Daily articles have discussed this issue, with almost a uniform favoring of cash flow:

• Not All Earnings are Created Equal: Follow the Cash
• Sustainable Dividends Depend on the Payout Ratio
• Free Cash Flow May Be King, But It’s Not Infallible
• Cash Is King: Why Cash Flow is More Important than Earnings

The poster child for cash-flow superiority was energy trading firm Enron, which went bankrupt in December 2001 after reporting positive earnings in 15 out of the last 16 quarters, yet positive free cash flow in only three of those quarters.

Accountants at FASB Know Best

Since Enron was a fraudulent criminal enterprise – and most corporations are not – I’m not sure that Enron is proof that free cash flow is king and earnings should be ignored. After all, paragraph OB17 of the Financial Accounting Standard’s Board’s (FASB) Statement of Financial Accounting Concepts No. 8 expressly states that accrual earnings are superior to cash flows in accurately representing a company’s financial condition:

Accrual accounting depicts the effects of transactions on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period.

This is important because information about a reporting entity’s economic resources and claims and changes in its economic resources and claims during a period provides a better basis for assessing the entity’s past and future performance than information solely about cash receipts and payments during that period.

To disagree with the professional accountants who run FASB and establish the generally accepted accounting principles (GAAP) required of all publicly-traded corporations seems to me to represent an act of extreme hubris. The accrual basis of earnings based on business process smooth out the lumpy and erratic timing of actual cash flow receipts and payments, thus making earnings arguably a more relevant indicator of a company’s true business value.

Academic studies (pp. 236-37), however, have found that the higher relevance of accrual earnings to a business’ true financial condition suffers from lower reliability than cash flow measurement. Paragraph QC12 of the Financial Accounting Standard’s Board’s (FASB) Statement of Financial Accounting Concepts No. 8 emphasizes the importance of “faithful representation:”

To be useful, financial information not only must represent relevant phenomena, but it also must faithfully represent the phenomena that it purports to represent.

Because corporate management has more discretion with accruals, earnings are only a better measure if you trust corporate management’s financial reporting. In other words, cash flow is better than earnings in a negative sense – as a check against fraud.

What about the findings of UC-Berkeley accounting professor Richard Sloan that companies with higher cash flows than earnings perform better? It turns out that Sloan is only measuring short-term stock performance over the following 12-month period (page 21). “Aggressive” accounting (i.e., earnings higher than cash flow) typically reverses itself in the following year or two, and it is this short-term reversal shock that causes stocks to move up or down with abnormal strength. Bottom line: unusual discrepancies between earnings and cash flow can be used for short-term trading, but does not offer evidence that cash flow is better than earnings for long-term buy-and-hold stock investing.

Predicting Short-Term Future Cash Flows Isn’t Very Useful

Evidence also exists that current cash flows are better predictors of future cash flows (page 458) than current earnings. Since most stock-valuation models are based on discounted cash flows (DCF), some studies conclude that cash flow’s better prediction of future cash flows means that cash flow is a better predictor of future stock valuation.

But a 2007 University of Maryland study disagrees, noting that stock valuation is based on a company’s entire set of future cash flows and most academic studies only measure a small sub-set of future cash flows:

For simplicity, most existing studies of cash flows prediction concentrate on a small number of immediate future years’ cash flows, and a majority on one-year-ahead cash flows. The noise in cash flows arises from fluctuations of cash flows that even out over multiple periods and thus are not priced.

For example, a bird in hand does not count if a bird this year implies one less bird next year. Also, why do we regress to cash flows after having evolved from cash flows to earnings (i.e., the accrual basis accounting) long time ago?

Similarly, a 2011 study looks at the predictive power of current cash flows over a three-year period of future cash flows and concludes that although current cash flow is better than accrual earnings at predicting the next three years of cash flow, current accrual earnings are better predictors of future stock value:

If researchers want to investigate how accounting numbers are related to stock prices, they should avoid using short term prediction tests, at least cash flow predictions, as proxies for value relevance studies.

The accrual component of earnings contains information relevant to the pricing of stocks even in cases where the accruals seem unrelated to short term future cash flows. In the long run accruals do provide information on the cash-flow generating capabilities of the firms.

The findings support the FASB statement that earnings are a better predictor of long-term cash flows, and thus company value, than are current cash flows.

As investors, the goal is to buy stocks of companies that will experience stock-price appreciation over the long term, not stocks of companies that are going to increase short-term cash flows. Doesn’t it therefore make sense to evaluate dependent variables like cash flow and earnings based on the desired direct outcome of future stock price and not simply indirect future cash flows? One study that performs the cash flow/earnings evaluation based on the future stock price three years in the future is a 2007 USC study: It chooses a stock-price target in three years because the short-term change in stock price caused by Professor Sloan’s observed mispricing of accruals does not persist beyond two years:

The objective of our study is to examine the relative importance of earnings and operating cash flows in equity valuation. We document that earnings are superior to cash flows in explaining ex post intrinsic values. This evidence supports the FASB’s assertion that accrual based earnings is superior to cash flows in providing information about users’ future cash flows.

The intrinsic value measure that we use captures the present value of all future cash receipts to the investors and, hence, provides a more formal and comprehensive measure of fundamental equity value than a finite horizon of future operating cash flows used in prior research.  

An earlier 2002 University of Illinois study utilized five-year rates of stock-price return rather than ending stock values, but reached a similar conclusion:

Hypothesis 1 asserted that free cash flows to equity (FCFE) would provide a more accurate estimate of capital gain rates of return than accounting earnings. The regression results in the study showed the opposite. Why is it that the accrual accounting information is more useful in explaining capital gain rates of return than free cash flow components?  Accrual information tends to be more stable than cash flow data.

Sales: A Cash and Accrual Mix That Predicts Well

Okay, so we’ve established the superiority of earnings over cash flow. But is there anything superior to earnings? According to a 2007 University of Southern Mississippi study, the change in aggregate sales (i.e., both cash and credit) is slightly more predictive of future stock price than the change in aggregate earnings and much more predictive than the change in cash flow. Sales are a good “compromise” financial metric because they capture both cash and accrual components of corporate wealth generation:

Because the majority of an entity’s operating cash flows derives eventually from its sales, it seems that this measure of financial performance could represent perhaps the most crucial component of accrual earnings with respect to its ability to predict future cash flows.

To be sure, aggregate earnings also represent both cash and accrual components, but sales comprise the vast majority of operating cash flow and thus are a direct determinant of business health and growth. In contrast, aggregate earnings include volatile changes in working-capital accruals (inventory, accounts receivable, accounts payable) and non-operational items involving investment depreciation and financing expenses. Earnings also can increase because of corporate retrenchment and cost-cutting, which actually may reflect a declining business, whereas sales only increase if consumer demand or pricing power underlying the core business is strengthening. The superior importance of sales growth compared to earnings growth may explain why investors continue to bid up the price of Amazon.com (NasdaqGS: AMZN) despite its mediocre earnings and stratospheric P/E ratio.

Money manager Ken Fisher discovered the special predictive powers of sales 28 years ago with the 1984 publication of the book Super Stocks, which popularized the price-to-sales ratio (PSR) as an important measure of value. James O’Shaughnessy, author of What Works on Wall Street, also utilizes PSRs in his very-successful “Cornerstone Growth” stock screen. In the latest fourth edition of his book, O’Shaughnessy discovered that the enterprise value-to-EBITDA ratio works even better as a value measure than PSR. EBITDA starts with earnings but removes a lot of the non-operational junk from the number, including debt expense, taxes, and investment depreciation. EBITDA and sales are both excellent value measures because they both focus on a company’s operational cash and accruals.

It’s Earnings That Count, But With a Cash-Flow Tweak

Besides isolating sales, there are other ways to disaggregate earnings to maximize predictive power. Hewitt Heiserman, author of It’s Earnings that Count, creates two separate income statements that differ from GAAP earnings by incorporating more cash-flow analysis in an effort to improve stock-price predictions. (First of all, notice that the title of his book focuses on earnings and not cash flow). Specifically, Heiserman creates a “Defensive” income statement that immediately expenses rather than capitalizes investments in fixed capital and working capital. By expensing these items, one can easily see if cash flow is negative – a red flag that would have come in handy with Enron.

Second, Heiserman creates an “Enterprising income statement” that “out-accruals” GAAP accrual earnings by capitalizing both research & development (R&D) and advertising costs, depreciating them over time rather than expensing them as GAAP does. The thinking here is that R&D and advertising are large costs that generate income over time, rather than all at once. This adjustment to the Enterprising income statement increases earnings above GAAP. On the other hand, Heiserman reduces Enterprising earnings below GAAP by treating shareholder equity as debt and imputes an annual interest expense associated with that equity capital based on a business-risk discount rate. GAAP earnings treat this shareholder equity capital as free money, whereas Heiserman wants to penalize companies that aren’t able to add value by generating investment returns above the cost of capital. Using a discount rate is a DCF concept used in cash-flow analysis.

If a company’s Defensive and Enterprising income statements are both positive and increasing over time, then the company is climbing an “earnings power staircase” and is probably a good growth stock to invest in.

Putting It All Together: Earnings, Sales, Cash Flow, and Valuation

In conclusion, the question whether earnings or cash flow is the better predictive measure of future stock performance is somewhat silly because they are both important and it would be foolish to focus solely on one and ignore the other. The accountants at FASB require public companies to report both an income statement and a statement of cash flows for a reason. That said, the academic research points to utilizing earnings (especially the sales component) as the primary stock-valuation criterion, with cash-flow data used secondarily as a safeguard against fraud, short-term insolvency, and poor utilization of shareholder capital.

Using my trusty Bloomberg terminal, I screened for stocks that that generate the 5-year compounded 10%-growth trifecta of increasing earnings, sales, and free cash flow. I also required that the stock be reasonably valued at less than 2 times sales and less than 7 times EBITDA. Lastly, I required that the stocks have a positive economic value added (EVA) and have appreciated in value over the last year to avoid value traps. Five stocks made the cut:

Stock	Market Cap	5-Year Sales Growth	5-Year Earnings Growth	5-Year Free Cash Flow Growth	EV-to-EBITDA Ratio	Industry
DirectTV (NYSE: DTV)	$30.2 billion	26.6%	27.2%	49.1%	6.18	Satellite Cable TV
Fluor (NYSE: FLR)	$10.2 billion	15.3%	21.3%	54.5%	2.61	Engineering and Construction
Western Digital (NYSE: WDC)	$9.6 billion	12.7%	11.0%	49.0%	5.93	Computer Data Storage
Community Health Systems (NYSE: CYH)	$2.7 billion	11.2%	17.9%	47.0%	6.52	Hospital
Darling International (NYSE: DAR)	$1.9 billion	12.6%	15.6%	13.8%	6.15	Waste disposal

Source: Bloomberg

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