Investors are faced with choices such as this everyday and investing life would be much simpler if only the picture each company portrayed was much clearer and convincing as to which company each of us should invest in. Ultimately, investors must choose. There is no perfect check list, though I use one. There is no one metric or ratio to guarantee success, though I use many of them. In other words, there is no magic bullet that any guru, checklist, analyst, etc., can offer you so that you know that your stock will increase in price. Only time can do that, along with Mr. Market acknowledging what hopefully was a wise choice.
Every day, investors must make decisions and use their very best judgment. Many seek out that one magic bullet that will separate one stock from the other. If you like reading, you will discover that there are many more metrics or ratios for determining the quality of a stock you intend to investigate. Some are more important than others.
One of the most important and helpful devices is the actual study of the financial statements. I have a copy of Enron’s 2000 annual report and occasionally review it, almost as a study guide. Would I have seen the problems before the demise? I would certainly like to think so. Luckily, I never owned it and I
would like to believe that based upon their statements, I never would have. But what exactly are we looking for or what should you be looking for?
Search the Internet, read a book on investing or follow the Piotroski (F-Score) and you will discover that a key metric watched by investors everywhere is that operating cash flow exceed net income. But is it a magic bullet? This is only one of many metrics that an investor should use, but let’s investigate this one a little more closely. Those that have followed or used the Piotroski F-Score and done any back testing will see that operating cash flow greater than net income is one of the most important of the scoring. One of the reasons that this is important is because its more difficult to manipulate the numbers on the cash flow statement. Not impossible — just more difficult.
Above is a portion of Walmart’s cash flow statement. You will note that the top line of the cash flow statement begins with net income. The bottom line shown here is cash flow from operations and is how a statement should look in a perfect world. But alas, we don’t live in a perfect world and not all stocks have this clean of a statement.
Look at Hi-Tech Pharmacal’s (HITK) cash flow statement below. Hi-Tech just received approval by the FDA for an oral concentrate of Lorazepam. Lorazepam is an often-used drug for the treatment of anxiety and is probably used by more Wall Street analysts than I care to know about. Note that the last three years indicate that net income is greater than operating cash flow. This is known as a red flag and should be investigated thoroughly if you intend to invest in any stock with similar numbers.
It’s important to understand that this may only be temporary, but you should investigate fully before you dive into any stock where net income is greater than operating cash flow. Remember that cash flow is an adjustment to net income and considers such items as depreciation and amortization which alter the net income figure considerably. Depreciation and amortization don’t actually require cash outlays and therefore don’t alter cash flow, giving a clearer picture of the company’s position. This is one of the reasons why investors prefer to look at cash flow instead of net income. Further, if the spread of the larger net income is huge, it may indicate that earnings may be less than useful for consideration.
Many investors will choose to use free cash flow over operation cash flow which I don’t suggest because there is no “approved” definition of free cash flow and it may differ from various sources.
Companies take their cash and make up their inventories which are stored until sold. When sold, they typically, if not receiving cash, go into the column labeled account receivables until the customer pays. So looking closer at Hi-Tech for the last three years, let’s note a couple of things:
The annual growth rate of the revenues annually is 17.87% with a five-year rate of 39.41%. Not bad, so where do we look from here? Think about what we just stated regarding our cash going into inventories and account receivables. Take a look at the trend of their receivables.
Take note that the receivables are growing much faster than sales, another red flag.
These and many more are the types of steps you need to take when evaluating a stock. Be diligent and be careful.
Finally, don't necessarily conclude that this is a bad investment. Joel Greenblatt did not think so. Look at his record:
Disclosure: I am long on WMT