Is Cash Flow King in Valuations?

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. The question addressed in the article is whether the balance tilts in favor of cash flows when the following are considered: (1) forecasts rather than reported numbers, (2) dividends rather than operating cash flows, (3) individual industries rather than all industries combined, and (4) companies in non-U.S. markets. In all cases studied, earnings dominated operating cash flows and dividends.Even though many finance academics and practitioners believe that operating cash flows are better than accounting earnings at explaining equity valuations, the evidence from recent studies suggests the opposite. For example, we previously investigated the performance of industry multiples based on a comprehensive list of value drivers for a sample of U.S. companies. Performance was measured as the ability of valuations derived from industry multiples to approach traded prices, and the value drivers considered included forward earnings; reported earnings; book value of equity; sales; earnings before interest, taxes, depreciation, and amortization; and various cash flow measures. Our results suggested that earnings clearly outperform other value drivers.In this study, we focused on a comparison of cash flows and earnings because of the prominence of these two measures in practice but we expanded our analysis in four directions to see whether cash flows outperform earnings in other contexts. First, we considered forecasts of cash flows in addition to reported numbers. Because analysts exclude in their forecasts the one-time items that tend to blur the relationship between reported numbers and value, moving from reported numbers to forecasts should improve the performance for both cash flows and earnings. The open question was whether the improvement in performance for cash flow forecasts would be large enough to overcome the initial performance gap between reported earnings and cash flows. Second, we broadened the definition of cash flows to consider both dividends and operating cash flows. Even though many companies do not pay dividends, we considered that dividends might outperform earnings for the subset of dividend-paying companies. Third, we compared the performance of earnings with the performance of cash flows within industries to determine whether for a subset of industries, dividends or operating cash flows would outperform earnings.Fourth, we considered nine markets in addition to the United States: Australia, Canada, France, Germany, Hong Kong, Japan, South Africa, Taiwan, and the United Kingdom. To the extent that factors such as accounting rules and the informativeness of dividends vary across markets, that variation could result in across-market variation in the performance of earnings, operating cash flows, and dividends.Our main finding is that valuations based on industry multiples using earnings forecasts are remarkably accurate. About half the companies had valuations that were within 20 percent of traded prices for the three markets where earnings forecasts performed well (Australia, the United Kingdom, and the United States) and were within 30 percent of traded prices for the three markets where earnings forecasts were the least informative (Germany, Japan, and Taiwan). In effect, the lead that reported earnings exhibit over reported operating cash flows and dividends increased when we considered forecasts. Although the earnings multiple was outperformed by operating cash flows or dividends in some industries—and in one market (Japan), where the performance of dividends approached that of earnings—the dominance of earnings multiples was very evident. Overall, our results suggest that proponents of using cash flow multiples consider using earnings multiples instead, especially if earnings forecasts are available.