Cash flow volatility-return relation and financial constraints: international evidence

Abstract

Purpose

The purpose of this paper is to examine whether cash flow volatility (CFV) has a negative impact on future stock returns, and whether the CFV-return relation is different among financially constrained and unconstrained firms, by using a broad sample of 21 developed markets.

Design/methodology/approach

The study conducts portfolio analysis to test the CFV effect on returns. Risk-adjusted returns (alphas) are computed with respect to country-specific factors based on market, size, book-to-market, and momentum.

Findings

The strategy of buying stocks with low CFV while shorting stocks with high CFV delivers significant alphas in more than three-fourths of the markets. The alphas for the long-short portfolio based on CFV are positive and statistically significant in more than 70 percent of the countries among financially constrained firms, largely driven by the underperformance of high-CFV stocks. In comparison, the CFV effect is observed in less than 45 percent of the countries among financially unconstrained firms, and is largely driven by the outperformance of low-CFV stocks.

Originality/value

This study extends prior findings by providing evidence of a negative relation between CFV and stock returns in a majority of global equity markets. The evidence also suggests an important role of financial constraints in explaining this relation.

Citation

Palkar, D.D. (2017), "Cash flow volatility-return relation and financial constraints: international evidence", Managerial Finance, Vol. 43 No. 3, pp. 354-378. https://doi.org/10.1108/MF-07-2016-0214