The argument over which metric, cash flows or earnings, better predict profitability has been ongoing for years. A recent study by Foerster, Tsagarelis, and Wang, looked at the mixed evidence and attempted to answer two questions using S&P 1500 from 1994 to 2013: (1) what the best method is to calculate cash flows and (2) which metric has the best prediction of profitability. They found that compared to other commonly used income statement metrics, cash-based measures are superior in measuring operating and gross profitability compared to total assets through their alternative “direct cash flow” method.

According to the article, alternative direct cash measures used by investors tend to outperform indirect cash flow measures, which are in turn deemed more effective than profitability measures. Among profitability measures, operating profit measures are considered superior to gross profit measures, and both of these outperform net income measures. By separating cash flows to take into account both investing activities and taxes, investors can access more comprehensive information for better investment decision-making.

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Jiaqi Liang, Portfolio Risk Analyst, Connect with Jiaqi on LinkedIn