Is Free Cash Flow Helpful in Investment Decisions? The Case of the U.S. Materials Industry Sector

Abstract

The purpose of this study is to identify the accounting definition of free cash flow (FCF) that is the most relevant to investors in the materials companies. Using correlations and multiple regression analysis on a sample of 12,121 observations covering the 30-year period from 1988 to 2021, the author concludes that the FCF that has the most significant association with stock price changes of materials companies, after controlling for many factors that may affect stock prices, is the one defined as cash flow from operations less cash flow for capital expenditures less cash outflow for preferred stock dividends. The author recommends that investors contemplating investing in materials companies choose companies with high FCF computed using this definition. The author further recommends that materials companies that wish to voluntarily disclose FCF in their annual report should use this definition of FCF.