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Cash Flow Trumps Discount Rate in Stock Valuations?

| | Posted in: Fundamental Valuation

Are expected cash flows (earnings) or expected discount rates (risk tolerance) more important in determining stock valuations? In the April 2008 version of their paper entitled “What Drives Stock Price Movement?”, Long Chen and Xinlei Zhao investigate the relative importance of cash flows and discount rates in equity valuation by studying the relationships among proportional stock price change, cash flow news and discount rate news at firm and aggregate levels. They make a critical assumption that analyst earnings forecasts are accurate and timely measures of investor beliefs regarding future cash flows. Using quarterly stock price data and contemporaneous prevailing earnings forecasts over the period 1985 through 2006, they conclude that:

  • Cash flow news significantly drives stock returns, with an importance that increases with investment horizon, at both firm and aggregate levels.
    • At the aggregate level, the portion of returns attributable to cash flow news is 16% at a quarterly horizon, 26% at an annual horizon, 46% at
      a two-year horizon, 63% at a three-year horizon and 80% at a seven-year horizon.
    • At the firm level, the average portion of stock returns attributable to cash flow news is 25% at a quarterly horizon, 69% at a two-year horizon, 76% at
      a three-year horizon and 84% at a seven-year horizon.
  • The conventional wisdom that cash flow news dominates at the firm level but discount rate news dominates at the aggregate level derives from flawed estimation methods.
  • Further, stock returns relate positively to cash flow news at both firm and aggregate levels.
    • Aggregate stock returns and cash flow news have positive correlations of 0.26 at a quarterly horizon, 0.41 at an annual horizon, 0.86 at a three-year horizon and 0.98 at a seven-year horizon.
    • Average firm level stock returns and cash flow news have correlations of 0.25 at a quarterly horizon, 0.52 at an annual horizon and 0.79 at a seven-year horizon.
  • The correlation between aggregate cash flow news and discount rate news is negative (-0.35) at a quarterly horizon.

In summary, cash flow expectations represent a significant positively correlated component of stock returns at both firm and aggregate levels. Their importance grows with investment horizon, dominating discount rate expectations for horizons over three years.

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