Cash flow has long been core to traditional value and growth approaches and to many fundamental beta and factor strategies. But are the most common measures of cash flow used by investors actually good predictors of future company asset values and market values?

The “direct method” of cash flow evaluation starts with the sales line, which includes all those recurring activities so attractive to investors. This is in contrast to the “indirect method,” which starts with net income, including less attractive nonrecurring and nonoperating activities.

To address the flaws in the indirect method, the authors introduce an approximation template to better measure cash flow provided by the recurring operating activities and thus produce higher-quality information that could allow investors to make more useful comparisons across sectors and geographies and arrive at better-informed stock selection decisions.

The authors also set out to test their view that cash flow measures are demonstrably better predictors of future value than income measures are.

It appears logical to focus on income in its various forms as a predictor of stock returns. Numerous academic studies have purported to show the importance of income-related measures.

Notorious bankruptcies, (including Enron and WorldCom), illustrate that positive income can coexist with negative cash flows for long periods. The authors believe that current accounting standards allow too much discretion for financial statements to be distorted by company management, making it difficult for investors to weigh the true economic value of a company. “The farther down the income statement one goes, the more ‘polluted’ profitability measures become,” say the authors.

The authors wanted to test their belief that companies that generate cash flow from irregular and nonoperating activities are not as highly valued as companies that generate cash flow from recurring skill-based activities. So, they sought a better way of measuring cash flow.

Most financial statements aggregate cash flows, both recurring and nonrecurring, which means that investors must attempt to identify cash flows by using indirect measures, such as free cash flow to equity. This study’s originality is in isolating individual cash flows that are derived from organic, recurring, value-creating activities and clearly separating these activities from nonrecurring operating, tax, financing, and nonoperating cash flows. This so-called direct cash flow method groups cash flows with similar economic characteristics and disaggregates those with dissimilar characteristics. It enables investors to isolate the value created by discrete corporate activities, something that is practically impossible to do when using cash flow statements prepared with the indirect method. The authors also backtested against sectors (excluding financials), since the cash flow issues raised are universal ones across industries.

Using the direct cash flow method also allowed the authors to build portfolios of companies with similar cash flow characteristics to test for return differences by cash flow type.

As a final step, the authors compared the various cash flow portfolios with portfolios of companies sorted by gross profitability, operating profitability, and the traditional return on assets (ROA) measure.

First, for each group of companies with similar cash flow characteristics, higher cash flows translated into higher market returns over the 20-year period of the study. Notably, stocks in the highest-cash-flow decile outperformed those in the lowest-cash-flow decile by more than 10% a year over the period.

Second, portfolios sorted by recurring value-creating activities performed better than portfolios where cash flows were derived from nonrecurring activities.

Third, cash flow measures were found to be superior to profitability measures for predicting stock returns, mainly because cash-related measures are “cleaner” than profitability measures. While operating profit was found to be a significant predictor of returns, it is less significant than any cash flow measure, including cash flow measures that are not predominantly derived from recurring value-creating activities.

Gross profit and net income, both frequently cited by analysts and commentators in their assessment of companies, were found to be poor predictors of returns.

The indirect cash flow method can confuse investors who are trying to understand what to extrapolate and how sustainable the value-creating activities are.

Portfolio managers may be able to obtain better information about investment prospects—and future stock returns—by relying on cash flows that disaggregate recurring value-creating activities from financing, tax, investing, nonoperating, and nonrecurring activities.

In addition, investors can potentially achieve superior risk-adjusted returns by replacing commonly used profitability ratios—including return on equity and P/E multiples—with cash flow. This reasoning is consistent with prior research showing that earnings targets influence accounting decisions, which creates an incentive to bias accruals.

Finally, the authors’ conclusion that they can obtain better information by distinguishing between types of cash flows lends support to initiatives of the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB). Both bodies are seeking to compel companies to break cash flows down into individual characteristics that can be analysed by investors.

The IASB is working with the FASB on potential guidelines through the Primary Financial Statements Project, and new standards are due in 2017. If adopted, these new standards will considerably raise the quality of information available to investors about the source, magnitude, frequency, timing, and volatility of cash flows.