The other day, we re-iterated the importance of the price to book metric by discussing the study undertaken by Bauman, Conover, and Miller that demonstrated superior returns of stocks in the lowest Price to Book quartile. In the same study, the trio studied relative returns of stock quartiles separated by Price to Cash Flow (P/CF). Cash flow is quite a volatile number, as it can be affected by a number of accounts including working capital, investments, loans, dividends etc. For the purposes of this study, Bauman et al. defined cash flow as simply earnings with depreciation (a non-cash charge included in earnings) added back.
Despite the simplicity of the concept, the value group (those defined as having the lowest P/CF) once again clearly outperformed the other three quartiles over the period of study as depicted below:
Unlike what we saw in the P/B study, the highest standard deviations actually belong to the companies with the highest P/CF. Changing predictions of expected future cash flows for this group may be causing relatively wild gyrations in its stock prices.
One of the conclusions drawn from this study is that investors are far too willing to overpay for "growth" companies. The median P/CF for the value quartile was 4.4 while it was a whopping 34.2 for the high P/CF group! This is why as value investors we prefer buying companies with stable cash flows and prices to those cash flows which are at reasonable multiples.