Financial analysis, future earnings and cash flows, and the prediction of stock returns: Evidence for the UK

Abstract

This study examines empirically whether fundamental analysis in the UK identifies equity values not currently reflected in stock prices and thus predicts excess returns. Similar to Ou and Penman (1989), the fundamental analysis undertaken combines a large set of financial statement information into one summary measure which indicates the direction of one-year-ahead earnings changes. Positions are taken in UK stocks on the basis of this measure during the period 1991-95, which involve cancelling long and short positions with zero net investment. This analysis is repeated i) for cash flows and ii) for earnings and cash flows together. The results of this study indicate that financial information predicts one year ahead earnings and cash flow changes, and that future earnings and cash flows are not fully impounded in stock prices. Results also indicate that an earnings-based trading strategy earns higher excess returns than a cash flow-based trading strategy.