The Investment Strategy of Free Cash Flow Multiple

Abstract

This study applies the investment strategy recommended by Hackel and Livnat (1993), the free cash flow (FCF) multiple, in Taiwan after the promulgation of Taiwan's FASB No. 95 in 1989. The results indicate that the portfolio with the higher FCF/Price ratio significantly rewards returns in excess of the market. Instead of using earnings/price ratio in the forming portfolio, the study shows that the decile portfolio with the highest FCF/Price ratio significantly outperforms the market during the period from 1990 to 1994. If daily returns are adjusted by the market model, the decile portfolio presents an average 20.5268% cumulative abnormal returns in the testing period, which is statistically higher than zero. The results also indicate that the annual cumulative abnormal returns of the FCF/Price ratio based portfolio are all positive. The annual results also show that the decile portfolio performs much better when the market declines significantly. The outperformance still exists if returns are adjusted by the market without considering risk. The decile portfolio presents an average 8.198% abnormal with a significant t value returns. The superiority of free cash flow in forming portfolio exists but with a decreasing trend when the portfolio is enlarged. The result implies that either the firms with extremely high FCF/Price ratios are undervalued by the market or the market responses slowly to their superior performance in cash flows. The finding supports Hackel and Livnat's (1993) arguments. It suggests that free cash flow is useful information especially for the forming portfolio. The results also enhance the usefulness of the statement of cash flow.