Cash Flow is King in Relative Valuation: A Myth or Reality

Abstract

In this article, the researcher evaluates the efficacy of two value drivers, namely, earnings per share (EPS) and cash flows for developing stock price forecasts using two performance evaluation criteria: (a) Root Mean Squared Error (Root MSE) and (b) Theil’s Inequality Coefficient. The examiner employs data for 13 sectors of BSE 500 from 1991 to 2010. The entire analysis is conducted in two phases. In phase one, the researcher finds that Price to Earnings (P/E) is the better stand-alone price multiple than Price to Cash Flow (P/CF) in the Indian context. In the next phase, the investigator shows that combination of value drivers does not significantly improve price forecast vis-à-vis stand-alone multiples. The findings of the study are in contrast with those for developed markets as shown by Penman (1996).

Keywords

Relative valuation price to earnings price to cash flow price multiples

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