Why cash profits are the best predictor of stock performance
Firms that are more profitable today on a cash basis could earn higher future returns.

 A line chart plotting the cumulative return on one dollar invested in 1963, with dollars on the y-axis and the years 1963 to 2013 on the x-axis. One line tracks cash-based operating profitability, which remains below twenty-five dollars until the mid-Nineties, after which it rises to nearly two hundred dollars. Another line tracking full operating profitability follows a similar path through the mid-Nineties but then rises only to about seventy-two dollars.

Returns for a portfolio of companies with strong cash-based earnings were more than double those for a portfolio based on operating profit or accruals.

  • Stock-pickers use a variety of earnings measures to predict companies’ stock-market performance. But simple, cash-based operating profit, which strips out the accruals included in operating profit (noncash components of operating profit, such as accounts payable and receivable, goodwill, and deferred tax or interest liabilities), is a better predictor of returns as far out as 10 years, according to research by Chicago Booth’s Ray Ball, Joseph Gerakos, Juhani Linnainmaa, and Valeri Nikolaev.
  • Between 1963 and 2013, stock returns for a portfolio of companies with strong cash-based earnings were more than double the returns for a portfolio of companies chosen based on operating profit—a more commonly tracked earnings measure—and a portfolio based on accruals, according to the study (see chart).
  • The researchers also find that a portfolio that combined exposure to companies based on cash earnings with factors traditionally associated with higher returns—such as size, value, and momentum—produced a higher risk-adjusted return than portfolios that combined these traditional factors with operating profit or accruals.
  • Including accruals in earnings figures is intended to give a more complete picture of a company’s profits. But while accruals can capture current performance (useful for evaluating employees, for example), the researchers argue that cash-based earnings are more informative about future stock returns.

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