IN SEARCH OF CASH‐FLOW PRICING

• Author: Frank J. Fabozzi,Jessica West,K. C. Ma,K. C. Chen
• Date: 01 December 2015
• Published date: 01 December 2015
• DOI: http://doi.org/10.1111/jfir.12085

IN SEARCH OF CASH-FLOW PRICING

Frank J. Fabozzi

EDHEC Business School

K. C. Chen

California State University at Fresno

K. C. Ma and Jessica West

Stetson University

Abstract

There are varying views on the relative importance of cash flow versus earnings in the

pricingof stocks. In this article, we identify which financial metric—cashflow or earnings

—is more often used by investorsin equity valuation and then investigate whyinvestors

focus onone more than the other. Our prior is that thepractice of deviating from cash-flow

pricing,if it exists, can be explainedby either rational herdingor information cascades.We

find that althoughstock prices are, on average, affected by short-termearnings, cash-flow

pricing is used primarilyto price what we classify as “negative”stocks—stocksthat are

generallycharacterized as illiquid, mispriced,or having a shorter trading history, negative

earnings, or negative marketperformance. We find evidence consistent with the rational

argumentof information cascades.For stocks under close public scrutiny,investors tend to

follow the decisionsof others and feel compelled to conform to the majority even though

their private informationsuggests otherwise. In the end, the choice to valuestocks with

either earnings or cash flow is still a rational one.

JEL Classification: G02, G10, G12

I. Introduction

The stock market has an unusual fascination with earnings. A company’s earnings,

measured under specific accounting standards and tax laws, are arbitrary at best, whereas

cash flow, like the balance in a checking account, is an actual number and subject to little

interpretation. In practice, a company could file for bankruptcy while showing positive

net earnings but negative cash flows on its financial statements.

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The importance of cash

flow over earnings is accurately portrayed in the following adage, “Earnings are opinion

and cash is a fact,”which was first recorded in the 1890s according to Hanke (2004), and

The authors appreciate the discussions with Jud Stryker, Jim Mallett, Chris Tobler, and comments from the

participants in the SOBA Research Seminar at Stetson University. The authors also gratefully acknowledge the

support from the SOBA Foundation of Stetson University. The editors provided useful feedback that helped

significantly improve the paper.

1

Fernandez (2013) uses Alpha Commerce as an example to show why a company could have positive net

income but negative cash flows.

The Journal of Financial Research Vol. XXXVIII, No. 4 Pages 511–527 Winter 2015

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© 2015 The Southern Finance Association and the Southwestern Finance Association

was echoed by Warren Buffett who wrote the following in the 1994 annual report to the

shareholders of Berkshire Hathaway:

We define intrinsic value as the discounted value of the cash that can be taken out of a

business during its remaining life. . . . Despite its fuzziness, however, intrinsic value is all-

important and is the only logical way to evaluate the relative attractiveness of investments

and businesses. (http://www.berkshirehathaway.com/letters/1994.html)

Moreover, at Berkshire Hathaway’s 2002 annual shareholders meeting,

Buffett stated:

We’ll [Berkshire Hathaway] never buy a company when the managers talk about EBITDA.

There are more frauds talking about EBITDA. That term has never appeared in the annual

reports of companies like WalMart, General Electric, and Microsoft. The fraudsters are

trying to con you or they’re trying to con themselves. (www.charleswarner.us/articles/

WarrenBuffett_EBITDA.doc)

The most celebrated investor’s message could not be clearer. In terms of value, it

is what you can take out of a business that really counts, not the earnings reported by the

company. The following, taken from Intel’sfirst-quarter earnings announcement in

2009, is a typical company quarterly announcement:

4Q revenues are down 19 percent sequentially at $8.2 billion; gross margin is down 53

percent, down 6 points sequentially; operating income was $1.5 billion, down 50 percent

sequentially.Quarterly net income is $234 million.Earnings per share is 4 cents. For2008 as a

whole, revenue was $37.6 billion,down 2 percent year over year, or up a touch if you adjust

for divestitures.Gross margin was 55 percent, up 3.5 points year over year. Operatingincome

was $9 billion, up 9 percent year over year. And annual net income was $5.3 billion, with

earnings per share of 92 cents. (http://www.intc.com/releasedetail.cfm?ReleaseID=377164)

It is obvious that the content of this quarterly announcement concentrated on

various earnings measures, because either “earnings”or “income”was mentioned six

times, yet “cash flow”was not referred to at all. In a typical quarterly announcement of

Fortune 500 public companies, earnings are often referred to 10 times more often than

cash flow (see Ma 2009b). While collecting data for this study, we noticed a large

disparity in publicly available earnings and other data. In part, this was the result of

federal regulations, which did not require publicly traded companies to report financial

results every quarter until 1987. Since then, the cash-flow information can be found in the

statement of cash flows of a 10-Q or 10-K report, though it is often overlooked in favor of

earnings in the income statement.

A major earnings-centric culprit is the equity analyst community, which has a

clear bias toward earnings when formulating forecasts. An examination of the widely

used Institutional Brokers’Estimate System (IBES) database indicates that only 15% of

the equity analysts reporting provide estimates on future cash flow, yet all of them

routinely make earnings forecasts. This evidence manifests the fact that for public firms

there is a disproportionate emphasis on earnings.

One problem with an earnings focus is that forecasts of future earnings have been

known to be overly optimistic. On September 21, 2001, despite a negative cash event,

512 The Journal of Financial Research