Earnings get all the attention on Wall Street. While earnings are of course important (and measures like P/E are very useful in stock selection), they aren’t everything. Less discussed, but equally important, is the cash that is flowing into and out of a company. Hidden in the statement of cash flows is an extremely useful tool for identifying great investments.
When a company releases its three financial statements, the income statement (led by bottom line earnings) dominates, the balance sheet comes second, and the statement of cash flows generally comes third. You’ll see a lot of “breaking earnings reports” on CNBC, but you’ll never see a “breaking cash flow report.”
This may be in part because the statement of cash flows has only been around since 1987, whereas income statements and balance sheets have been around forever. In the cash flow statement, cash flows are grouped into operating, investing and financing categories. Operating cash flows dominate—these are inflows and outflows resulting from normal business operations. Investing cash flows matter too, because they reveal how much a company is investing in things like machines, office buildings, and the like. But financing cash flows are the most useful for investors.
Financing cash flows are pretty straightforward. Positive numbers (cash coming into the company) result when a company raises cash from outside stakeholders (through debt or equity offerings). Negative numbers (cash leaving the company) result when a company sends cash back to stakeholders by repaying debt, paying dividends, or buying back shares.
It turns out that companies with the most negative flows, relative to their market value, perform considerably better than those with the most positive flows and perform better than the overall market. The factor (financing cash flows divided by market value) is sometimes called “shareholder yield,” but I prefer “stakeholder yield” because it doesn’t belittle the creditors who are not technically equity shareholders. Here are the annualized results, since 1987, for stocks broken into decile groups by stakeholder yield.
The bottom line is that following financing cash flows has been extremely useful in the past, and you ignore them at your own peril.
NOTE: This factor has received attention (notably in Jim O’Shaughnessy’s What Works on Wall Street, in Meb Faber’s Shareholder Yield, and in academic papers), but still remains fairly under the radar. In this example, I only run the numbers since the statement of cash flows was first reported in 1987 and only use data directly from the cash flow statement (although the factor can be extended to 1970 using other data, as I did in a previous piece).