One of the most basic is to look at the firm’s earnings. Historically, if earnings consistently grow, so does the stock price.
But I prefer another, more accurate measurement of a company’s performance – cash flow.
Cash flow is the amount of cash the company actually generates after all is said and done.
Think of the difference between earnings and cash flow like the difference between your income that is reported to the IRS and the actual amount of money you make during the year.
You only have to take a look at Enron to understand why it’s important to understand cash flow…
Why Cash Flow is Crucial
Former Enron CEO Jeffrey Skilling reportedly once asked, “What earnings do you need to keep our stock price up?” He would then deliver or beat those numbers in the company’s earnings reports.
As you know, Enron manipulated its earnings so its share price would stay high. That’s becauseearnings reports can be manipulated. But cash flow is much more difficult to tinker with.
In 2001, Fortune magazine’s Bethany McLean broke the Enron scandal when she found “erratic cash flow,” despite the company’s supposedly strong earnings.
In fact, starting in June 1997, Enron reported positive earnings in 15 out of 16 quarters, yet cash flow was positive in only three quarters.
So when earnings are strong but cash flow is not, it’s often a warning sign that there are problems.
There are a couple of different cash flow terms that you need to know…
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Operating Cash Flow: This is equal to net income plus amortization and depreciation, minus capital expenditures and dividends. Amortization and depreciation are added back to earnings because they’re non-cash items. So to accurately reflect the amount of cash the business is generating, it needs to be added back into net income.
The difference in accounts receivable from one period to the next are also taken into consideration here. If receivables have decreased, that means more cash is coming into the company (possibly from sales booked in prior periods). On the flip side, an increase in receivables means that even though the company booked the sale and may have counted it as revenue during the reporting period, it may not have received the cash.
Free Cash Flow: This includes operating cash flow, plus or minus cash used or generated by investments and financing.
For example, if it’s a one-time major sale that is on a company’s books, but hasn’t yet been paid for (receivables go up), then it’s probably not an issue. But if you consistently see a difference in the direction of earnings and cash flow, you may want to rethink owning that stock.
Earnings Are Strong… But Cash Flow Is Weak…
Let’s take a look at a company whose earnings are strong, but cash flow is weak…
- Gafisa S.A. (GFA): This Brazilian homebuilding company has grown its revenue, operating income, net income and earnings per share every year since 2003. In 2009, the company earned $106 million or $0.67 per share.
But the cash flow numbers tell a different story. Cash flow from operations has been in the red since 2005, including a whopping $388 million shortfall last year.
Just a cursory look at the financials makes me wonder how the company can report growing earnings every year, while burning more cash to run its business.
And now for the flip side…
- Dr. Pepper Snapple Group (DPS): The soft drinks manufacturer did a good job weathering the recession and grew both its earnings and cash flow from operations in 2009. In fact, the company has increased cash flow from operations each year since 2007.
Price-to-Cash Flow Ratio vs. Price-to-Earnings Ration
When it comes to valuing stocks, the price-to-earnings (P/E) ratio is burned into many investors’ heads.
As a general rule:
- We know that a P/E in the low teens or single digits means the stock is fairly inexpensive (depending on the sector),
- While a P/E in the 20s or higher is pricey.
- If you’re looking for a bargain, a good rule of thumb is to try to find a stock with a price-to-cash flow (P/CF) ratio below 10.
Luckily, when we report our income to Uncle Sam, he only sees our “reported” earnings. But as investors, we have the luxury of peeking behind the earnings curtain and examining how much actual cash a company generates.
Use this powerful tool to better understand the companies you’re investing in.
Hoping your longs go up and your shorts go down.