Cash Flows, Earnings Quality, and Stock Returns

One of my original purposes in starting this blog was to create a place to keep track of things I came across on the Web that might be useful in my classes. I just found another one: "Cash Flow Is King: Cognitive Errors by Investors" by Todd Houge (of U of Iowa) and Tim Loughran of Notre Dame. Here's the abstract:

When investors fixate on current earnings, they commit a cognitive error and fail to fully value the information contained in accruals and cash flows. Extending the accrual anomaly documented by Sloan [1996], we identify significant excess returns from a cash flow-based trading strategy. The market consistently underestimates the transitory nature of accruals and the long-term persistence of cash flows. We find that the accrual anomaly derives from the poor performance of high accrual firms, which are more likely to manage earnings. Combining the accrual and cash flow information also reveals that investors misvalue the quality of earnings. Contrary to Fama [1998], these anomalies are robust to the three-factor model with equally or value-weighted portfolio returns.

Houge and Loughran find that markets undervalue firms with high operating cash flows to asset ratios and overvalue those with low cash flow/asset ratios. Somewhat surprisingly, Cash Flow/Assets is negatively correlated with Book/Market ratios (i.e. a firm with low CF/Assets is likely to also be a high Book/Market firm), so this is not just another way of capturing the value anomaly. They also find that the negative returns for high accrual firms are mostly evident among firms with the highest accruals.

But the really interesting finding in the paper has to do with earnings quality. The high cash flows/low earnings combination (basically, low accruals) indicates high earnings quality, while low cash flows and high earnings (high accruals) proxies for low earnings quality. When they compare returns to high cash flow/low earnings firms to those with low cash flows and high earnings, the high CF/low earnings firms outperform their opposite numbers by almost 16% per year on a risk adjusted basis. Not too shabby.

The paper was published in the Journal of Psychology and Financial Markets in 2000, but you can get an ungated version here.