Cash Flow Vs Share Prices

Published: 2021-09-11 22:25:11
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Category: Corporate Governance, Management, Finances

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What do investors rely on when valuing stock; cash flow or earnings? Fabozzi, Chen, MA and West (2015) found that short term earnings are mostly used to price stocks, where cash flow is usually used to price negative stocks. Most reports focus on earnings and not cash flows, which can be problematic as earnings forecasts have been known to be overly optimistic. This exaggeration of earnings has been termed as myopic behavior – where investors focus on short terms earnings.
Managers are sometimes paid based on earning goals which provide a reason to focus on producing short term results. Investors tend to follow the crowd; they continue to base their valuations on how it has been done before and how everyone is doing it. The authors state that this may reflect humans’ need to belong to society. It may have been beneficial for the authors to further research the reasons why investors ‘follow the crowd’.Ma, Pace and Stryker (2015) state that stock prices are mainly affected by short term earnings and sales per share are a more meaningful measure than earnings per share. This is conclusive with results found above. Mostafa and Dixon (2012) researched the value of using the incremental information content of cash flow from operations and earnings and the effect of extreme earnings thereon, indicating that investors can make use of cash flow information in addition to earnings information, especially when earnings are extreme and cash flows are moderate. I think this article makes a valid point in using both cash flow and earnings information.
Eshleman and Guo (2014) provide evidence that the quarterly earnings announcements of suppliers contain information about their customer’s earnings– that a downward stream of information occurs when news of the supplier’s earnings affects the stock price of the customer firm. These results are however not conclusive that other factors do not play a role.
An approach that is broader to those above is explored by Miah and Baca (2014) – investment bankers don’t always look at numbers. They look to the future of a firm – their growth prospect, future market conditions and product cycle. Companies that have positive earnings can suffer a decline due to market conditions. Some competitors will not make it. Others may obtain a new infusion and make a comeback. This offers investors who are willing to take calculated risks new investment opportunities. I think it is important for investors to follow this approach combined with an examination of the current and forecasted cash flows of the firm.
Gardner, McGowan and Moeller (2012) used the free cash flow to equity valuation model to value Coca-Cola, which was proposed in Damodaran (2006). The value of the equity of a firm can be calculated as the present value of all future cash flows from the firm to the shareholders. They value the firm using free cash flow to equity divided by the sum of the required rate of return for equity minus the growth rate of the firm’s earnings. Free cash flow to equity is computed by subtracting net capital expenses and the change in net working capital from net income and adding the net change in long term debt financing. This research is limited to the company it is based on and could be more useful if conducted on various firms in a variety of sectors, however it does give an indication of what model can be used to value a firm.
Which free cash flow is most associated with stock prices? Maksy (2013) attempts to identify which definition of FCF will be most relevant to users of accounting information to be able to better predict stock price changes and make better investment decisions. The author cited the seminal paper by Jensen (1986) which hypothesizes that free cash flow increases agency costs as managers of firms with FCF tend to invest in negative NPV projects to satisfy their egos and possibly increase their compensation.
This theory was proved by showing that these firms have a lower return on investment after such an acquisition. FCF should rather be distributed to shareholders by way of dividends and any acquisitions should be made using borrowed capital. Creditors can force a firm into bankruptcy and this can stop managers from investing in negative NPV projects. The focus of this study is of the healthcare sector, which can be limiting, and concludes FCF should be defined as cash from operations less capital expenditure. However, it further states that the definition cash flow from operations less capital expenditure required to maintain production capacity less preferred stock dividends is also significantly associated with stock price changes, overall.
In the first paragraph, a significant point was identified: managers are often compensated based on earning goals. I want to explore how compensation linked to earnings may affect the share price. Danielson, Heck and Shaffer (2008) wrote a very interesting article where they discuss the shareholder and the stakeholder theory, pointing out that shareholder wealth maximization is commonly accepted by financial economists as the correct objective for financial decision making.
This approach has been criticized as encouraging short term thinking, which focuses on short term profit maximization at the expense of the long term profits of a firm, and for condoning unethical behavior. The authors, however, refer to research conducted by Jensen (2002) and Sundaram and Inkpen (2004a) that states that this belief is misguided, as wealth maximization is inherently a long term goal and that the firm does not exploit other stakeholders.
Opponents of this theory recommend that firms should balance shareholder interest against that of other stakeholders. This stakeholder theory can however also lead to short term thinking if the future interests of all stakeholders are not considered. Should a firm’s business environment change unfavorably, the firm’s maximum value may decrease. If the unfavorable conditions continue, the price of the share will exceed the value of the shares thus the shares will be overvalued. In order to implement the shareholder theory correctly, the firm should continue to invest in positive NPV investments, which are now lower in value than first expected, and thus the share price will then drop to the new intrinsic value.
However, the authors make use of research conducted by Jensen (2006) and Danielson and Press (2006), which I find very important: should managers have the incentive to keep inflating the share price, they may take actions such as delaying new investments, reducing discretionally spending for example advertising and research and developments costs, manipulating accounting records and adopting fraudulent business practices, and in doing so they may destroy the long term value of the firm.
To further explore this point, I have included an article written by Strobl (2014) who looks at the relationship between a firm’s managerial incentive scheme, the informativeness of its stock price and its investment policy. By aggregating information obtained from dispersed investors, the stock price can provide the firm with a way to measure managerial performance. This relies on the quality of information that is reflected in market prices. A firm’s investment policy affects the investors’ decision to provide information, and in turn this affects the efficiency of managerial compensation contracts. This supports the research by Heck and Shaffer (2008) documented above, that a shareholder’s concern over stock based compensation can lead to overinvestment.
Importantly this research does not rely on the belief that over investments are caused by managerial incentive contracts. A significant result of this study is that, yes, stock based incentive contracts can lead to over investment, however, this serves to encourage information production by outside investors. It is the owners of the firm, not the managers who have the incentive to overinvest. This supports the research above however is contradictory by saying that managers do not have an incentive to overinvest.
Cheung and Jiang (2016) identifies that Jensen’s free cash flow problem contributes to stock return synchronicity. Firms with a free cash flow problem manage their earnings more and increase stock return synchronicity. Managers are able to use the firm’s resources for their own private control benefit by making the firm less transparent and their stock prices less informative.
Hong, Kim and Welker (2017) look into the deviation between ownership (those who hold cash flow rights) and control (those who have voting rights) and whether this influences stock price crash risk. The deviation is referred to as the ownership-control wedge. The study is based on research performed by Jin and Myers (2006). Firms with a dual class share structure from 20 countries were considered. The authors find that the effect of agency conflict risk differs between high and low opacity firms. Their findings are consistent with those of Jin and Myers (2006); stock prices have a higher price crash risk when agency conflicts between corporate insiders and outside stakeholders are combined with information opaqueness. This article raises an important point – that this deviation should be avoided in order to avoid conflict between owners and in doing so encourage openness of information.
In support of the above research; Jiang, Kim and Pang (2004) state that stock price informativeness decreases with control-ownership wedge. It is also noted, which I feel is important in resolving this problem, that strong country level institutions help to mitigate firm level governance problems. Another approach to how a firm’s stock can be valued is explored by Beyer (2009). An owner – manager may release a forecast of the firms’ earnings and then later release the actual earnings for the period, which may have been manipulated, in an attempt to maximize the firm’s capital market value.
This model is based on the belief that investors use the information they receive of the firm’s earnings to form their opinion of the unknown mean and variance of its cash flows. The manager has an incentive to manipulate both the forecast and the actual report so that the investors assume the expected cash flows will be high resulting in the variance of the cash flows being low. The author has made an interesting point however I feel further research can be conducted combining this model with the motives behind the incentive to manipulate the reports.
Broughton and Lobo (2014) examine the sensitivity of stock prices to discount rate changes and cash flow timing. This concept is known as equity duration. Growth stocks have higher duration than value stocks and are also more volatile. It is thus more effective in predicting actual price changes for value stocks. This research can be helpful when determining how share prices can be predicted as part of an investor’s attempt to value a firm.
Ma and Wohar (2014) investigate how expected returns and expected dividend growth contribute to movements in the price-dividend ratio, by examining state-space and Vector auto regression (VAR) model specifications. When using the VAR model, they defined dividends in the traditional sense and in a broader sense – net payout. When both the state-space and VAR models are used, expected returns contribute to most of the movement in the price –dividend ratio when traditional dividends are used.
Earlier empirical work is subject to inference problems. When inference measures are applied it can be concluded that aggregate returns and dividends data does not provide enough evidence to support the theory that expected returns can explain the majority of the movement in the price-dividend ratio when dividends are used as the cash flow measure. They conclude that expected net payout contributes to the majority of the movement in the price net payout ratio when the broader definition is used in the VAR methodology.
Another topic I considered is share repurchases. Chan, Lai and Wang (2013) cited research conducted by Chan et al. (2004); Ikenberry et al. (1995); Lie (2005); Peyer and Vermaelen (2009) and Grullon and Michaely (2004); Nohel and Tarhan (1998), which notes that the most common theories for share repurchases are the information signaling hypothesis and free cash flow hypothesis. The information signaling hypothesis suggests a motive for the firm to buy back their shares when they are undervalued where the free cash flow hypothesis suggests a way for the firm to distribute excess cash flow to avoid wasteful investments.
The authors suggest a motive for share repurchases is based on the firm’s life cycle stage – firms in the early life cycle phase tend to have a higher and positive value to price ratio (abnormal free cash flow ratio) than firms in the later stage. Firms in a growth phase thus repurchase shares to signal undervalued stock, where firms in a mature phase buy back shares to dispense free cash flows.
Lui and Swanson (2016) discuss their theory that share repurchases are increasing with the motive of supporting overvalued equity. An important factor to note is that this research is based on averages and is this not applicable to all companies.
Almeida, Fos and Kronlund (2016) state existing evidence shows that share repurchasing is a good way to return money to the investors. However, some believe that excess cash should be used to increase employment and research. Repurchases have been identified as a reason for why an increase in corporate profitability has not led to an increase employment and an overall economic prosperity. Repurchases that are driven by EPS, result in firms decreasing employment, research and development and investment. It is important to note that this does not appear to effect shareholder value negatively, unless the cuts in real investments happen in the same time frame as the share repurchases.
De Ridder (2015) researches the effect of the frequency of repurchase programs on the returns earned by the firm and the relationship between the level of cash flows of a firm and their returns. Her research is conducted based in Sweden, so it may be limited in its findings, in relation to the rest of the world.

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