Why Free Cash Flow Better Determines Profitability Than Earnings

While earnings have long been the yardstick for determining a company’s profitability, they can also be misleading. After all, the bankruptcies of Enron and WorldCom in the early 2000s demonstrated that strong GAAP earnings don’t necessarily mean a company is sustainably profitable.

A survey of 400 CFOs conducted in 2014 showed that the respondents believed that in any given period, 20% of companies intentionally distort earnings, even while adhering to GAAP. The magnitude of the misrepresentation is 10% of reported earnings. GAAP accounting provides several opportunities for management to distort earnings, with researchers finding 44% of adjustments from an auditor perspective.

A white paper written by FCF Advisors portfolio manager and senior quantitative analyst Vince (Qijun) Chen argued that when it comes to equity valuation, free cash flow provides a clearer picture of a company’s profitability. Both free cash flow profitability and yield have historically demonstrated strong predictive power, outperforming their earnings peers.

“Investors who rely on earnings to assess a company’s intrinsic equity value and predict future stocks return may suffer from a significant magnitude of management manipulation,” wrote Chen. “Unlike earnings, free cash flow provides a better picture of a company’s profits because it doesn’t require managers to estimate the realization of future cash flows related to contemporaneous accruals, leaving much less space for discretionary accounting, and becomes less sensitive to the level of uncertainty in reflecting firm profitability.”

FCF Advisors specializes in free cash flow investment strategies, primarily through its Free Cash Flow Quality Model. The firm has been focused on free cash flow factors since 2011 and focuses on multi-factor fundamental analysis grounded in decades of research. Two exchange traded funds that FCF Advisors offers that specialize in free cash flow are the FCF US Quality ETF (TTAC) and the FCF International Quality ETF (TTAI).

TTAC aims to outperform the Russell 3000 through a fundamentals-driven investment process that selects about 150 stocks based on free cash flow strength. Its holdings are then weighted by a modified market-cap log transformation, allowing increased exposure to companies with the strongest proprietary free cash flow rankings.

TTAI, meanwhile, aims to outperform the MSCI All Country World Index ex the U.S. through an active investment process. A quant model is used to rank stocks based on proprietary measures of free cash flow. Highly leveraged firms that incur debt to buy back shares, or don’t satisfy ESG criteria, are screened out. Roughly 150 of the highest-ranked stocks are selected and then weighted on a modified market-cap basis that factors in free cash flow and log transformation.

Both ETF portfolios will also be rated with an ESG score, excluding companies with low ESG ratings. Firms with an extreme rise in shares count and increase in leverage are excluded.

For more news, information, and strategy, visit the Free Cash Flow Channel.