If you follow equities, you are undoubtedly familiar with the many flavors of financial metrics and ratios (e.g., profit margins, price-to-earnings, price-to-cash flow, dividend yield, and the like) used to describe equity markets. But do any of these indicators have anything to do with future stock returns?
If you’ve ever wondered this, well, you’ve landed in the right place. In this post, we rank the raw correlations for 20 common financial metrics and the S&P 500 Index’s next 12-month return over 372 rolling annual periods from January 1991 through December 2021. For the punchline, feel free to read on……
Financial Metrics in the Study
The 20 metrics we chose to study can be grouped, by design, to reflect different financial statements (income, balance sheet and cash flow) from which they are derived. We also have one metric, total employees, that is a non-financial statement statistic as shown in the following table.
Study Time Period and Basic Setup
Nothing overly fancy, we just take the raw correlations between each financial metric and then subsequent S&P 500 Index total return for the following 12-months. So, for example, say we take the S&P 500 Index’s profit margin at January 1990, we’ll take that and match it with the S&P 500 Index return over the next 12-months (from January 31, 1990 to January 31, 1991) and repeat the process each month all the way through December 31, 2021. This gives us a sample of 372 rolling annual periods that we can use for correlations between each metric and the one-year in-the-future S&P 500 Index return.
Ranking Financial Metrics and Future S&P 500 Returns
Now for the punchline. The attached table provides the correlations ranked from positive to negative. And the winner is……..Free Cash Flow Yield!
Free cash flow yield showed a positive correlation of 0.36 versus the future 12-month S&P 500 Index return. This indicates that higher free cash flow yields are somewhat linked with positive future S&P 500 Index equity returns. Dividend yield had the next highest positive correlation at 0.32.
We also need to check for strongly negative correlations since these are useful. Here the standouts are total debt (-0.26 correlation) and price-to-earnings (-0.25 correlation). For these metrics higher numbers are correlated with poor equity returns and vice versa, lower debt and P/Es are correlated with better returns.
The odd thing was how many widely quoted metrics have hardly any correlation to the future year S&P 500 Index returns. In this camp, profit margin, operating margin, earning per share, return on common equity all exhibited close to zero correlation with future year stock returns. And this result is something to think about the next time you hear one of these numbers from a so-called expert!