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Cash flow analysis has distinct advantages to investors, because it strips out some of the more nefarious forms of accounting manipulation in reported earnings per share. And right now, it also paints a rosy picture for investors in the S&P 500.
Unlike earnings, which can be boosted by vague accounting entities like amortization and loan loss provisions, cash flow can offer a clean look at corporate profitability from normal operations. The price to cash flow multiple, along with enterprise value to EBITDA, was touted as the most effective predictor of future equity performance by respected Bank of America quantitative strategist Savita Subramanian.
This chart looks a bit messy, but it actually tells a simple story. Using monthly data beginning in 1998, each dot represents the price to cash flow (PCF) multiple for the S&P 500 and the return of the index in the following 18 month. The dot in the top left, for instance, displays a month (September of 2007 in this case although the dates are not plotted in this type of regression study) where the PCF multiple was 20.43 and the -47.74 per cent S&P "return" during the following year and a half.
The downward-sloping trend line is the key feature of the chart. It shows mathematically that the higher the PCF multiple (y-axis) the lower the future returns are likely to be, and also, that the reverse case is true. The R-squared of 0.4654 is high, indicating that the trend is significant.
If low PCF multiples imply higher future returns, then we have good news – the current PCF of the S&P 500 is 9.04 times, which is significantly below the 11.8 times average for the period. According to our chart, this means the probability of above-average returns from the S&P 500 is high for the next 18 months.
Investors should avoid making investment decisions solely based on one valuation metric. Still, the results here are encouraging for those sitting on the fence wondering whether to put more money to work.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.