Net Income Verses Free Cash Flow

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:

  1. 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.
  2. 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.
  3. 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.

This term backtests each decile of earnings vs cash flow, grouping by sector.
This term backtests each decile of earnings vs cash flow, grouping by sector.

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.

Chart of deciles to total performance.  The first decile (lowest values)  turns one dollar into 10, while the next decile turns one dollar into  18.5!
The first decile (lowest values) turns one dollar into 10, while the next decile turns one dollar into 18.5!

What happens if we decide not to group by sector?

Chart of deciles, no grouping.  This time the second decile wins, and the highest decile gets the lowest returns.
This time the second decile wins!

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?

About henry information

Henry Crutcher is an avid family guy, board gamer (think Settlers of Catan, Puerto Rico, etc), computer nut, and all around geek. Hailing from Louisville, KY, he has noticed that the weather in Louisville is remarkably similar to the weather in Atlanta, GA despite the 407 miles that separate them. He has two daughters, one cat, and lots of trees. He loves the Miles Vorkosigan series from Lois McMaster Bujold, for its mix of SF, comedy and insight into how people work. He also comsumes more than his fair share of cheesy business/economics books, such as The Ascent of Money by Niall Ferguson, or Farewell to Alms, by Gregory Clark.

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