Is cash flow or earnings a better indicator of stock valuation? In their August 2006 paper entitled “Cash Flow is King? Comparing Valuations Based on Cash Flow Versus Earnings Multiples”, Jing Liu, Doron Nissim and Jacob Thomas extend their prior work on comparing cash flow and earnings as indicators of firm market valuation. The authors assume that financial markets efficiently price stocks and compare the accuracies with which different simple valuation ratios predict stock prices. They hypothesize that: (1) earnings should outperform cash flows as predictors of valuation because earnings include information about both cash flow and accruals; and, (2) forecasts should outperform historical results as predictors of valuation because forecasts typically exclude non-recurring events. Using data from the prior study for the U.S. (1992-1999) and for a large sample of firms across ten international markets (1987-2004), they conclude that:
- In all markets, earnings generally outperform both operating cash flows and dividends as predictors of firm market valuations.
- Forecasted earnings generally outperform historical earnings, forecasted cash flows and forecasted dividends as predictors of firm market valuations.
- Forecasted earnings outperform forecasted cash flows as predictors of firm market valuations for more than three quarters of all industries.
The following table, taken from the paper, compares market valuation error statistics for various measures of value, or “value drivers,” for the U.S. sample. Mean and median errors, and the standard deviation of errors (SD), are smallest for earnings-related measures. In addition, forecasted earnings are generally more reliable indicators of market valuation than historical earnings. The last three columns are other measures of dispersion of errors based on the ranges between percentile levels.
Note that the authors define earnings as “a corporation’s net income from continuing operations (i.e., income after backing out discontinued operations, extraordinary charges, and other non-operating items).”
In summary, operating earnings forecasts are the best simple indicator of stock market valuation.
