Show me the money
People look at net income, otherwise known as just earnings, as well as Free Cash Flow to decide whether they like a company. Why? Net income is the “real” income the firm makes, but it has one weakness: it doesn’t actually track money coming into (or out of) the firm. If Boeing sells a new 737 Max, it records a large chunk of income. And no cash flow. Some time later, it keeps spending money to build that plane. And certify that plane (or not….). When the customer gets cold feet, and cancels the order, the income drops, but nothing happens to the cash. It never came in, and it doesn’t have to go back.
So, what does this mean for stocks. Should you pay more attention to the income, or the free cash flow? There are three possibilities:
- Income is more meaningful than free cash flow, and investors are not fully aware of this. In this case, stocks with higher income relative to their cash flow will outperform.
- Cash flow is more meaningful than income, and investors are not fully aware of this. This should lead to outperformance by stocks that have more cash flow relative to their income.
- The relationship is complicated, or not there, or investors are already aware of it. In this case, neither set should clearly outperform.
We test this first by ranking stocks by their income / cash flow versus the other stocks in their sector, after excluding stocks that have negative cashflow or earnings, or whose market caps are less than 1 billion.
When we run this from 1996 to present, we see that the lowest values of the ratio gives the worst performance, while the next lowest decile gets the best performance.
What happens if we decide not to group by sector?
Again, there’s not much of a clear relationship. It’s slightly tempting to say things like: the edge is less good than the middle, but that seems like torturing the data. What do you think?