Predicating Stocks Returns

I have been noticing (while reading several articles) that a few financial analysts believe profitability should not be the essential sole predictor for stock returns. Obviously, most investors concentrate on financial information and earning prospects to both evaluate a firm’s intrinsic equity value and anticipate the cross section of average returns. Typically, most investors utilize profitability measures to come up with better predictions about the expected returns. Yes, it’s true that, in 2006, Fama and French found that corporations that are more profitable would generate higher returns. However, in 2013, Novy-Marx suggested that profitability is not the single method (tool) to use in order to measure cross section of average returns, book-to-market ratio can be utilized as well.

Historically speaking, there have been some corporations that have gone bankrupt while having profitable income statements. For instance, Enron and WorldCom showed that profitable GAAP income statements can survive while having negative operating or free cash flows for years. Therefore, investors might make inaccurate and poor financial decisions when focusing solely on income statements. Instead, investors should analyze a firm’s cash flows as well.

Sometimes, it would depend upon what kind of a firm investors are trying to evaluate and predict its earnings. In other words, financial services companies (e.g. banks, insurance firms, etc.) are sort of difficult to value because it’s a bit complicated to analyze their cash flows due to unclear definition of capital expenditures and working capital. However, on a large scale investors and analysts should look at more than one parameter (income statements, cash flow statements, etc.) to come up with informed recommendation on purchasing new stocks.

Ahmed Almuhr