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Cash Flow: One of the Most Accurate Ways to Analyze a Stock's Value: Gafisa S.A. vs. Dr. Pepper Snapple Group

June 23, 2010 | About:

What’s the best way to analyze a company’s stock?

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…


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.
Keep in mind that when you come across a company with positive earnings and negative cash flow, it doesn’t always mean there’s fraud. But you may want to take a close look at why this is happening.

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.
On the surface, these are impressive results.

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.
And due to its prominent position in the beverage business (aside from Dr. Pepper and Snapple, its other brands include 7Up, Schweppes, Canada Dry, Sunkist, Welch’s and Nantucket Nectars), Dr. Pepper generates hundreds of millions of dollars in cash each year. This ensures that itsdividend gets paid and it can re-invest in growing the business even more.

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.
But like earnings, you can get an idea whether a stock is cheap or expensive by using cash flow. And it’s quite simple…

  • 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.
For example, Dr. Pepper Snapple Group is trading at just six times cash flow, while the broad S&P 500 is trading at a P/CF of 10.9.

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.

Good investing,

Marc Lichtenfeld


Rating: 3.1/5 (22 votes)


Toddius - 10 years ago    Report SPAM
Great article.
Kfh227 - 10 years ago    Report SPAM

Am I the only one that here "cash flow" as "cash flow from operations" and not "free cash flow"?

Anywasys, look at several years of data. If there is a pump in cap ex or cash from ops, understand why. USG is a very good lesson. Everyone should look at it and understand what happened right around 2006. When looking at USG, I usually omit that year as a one time occurance type of situation.

Also, I have taken a look at Enron in the past. No one calling themselves a value investor should have bought it. The FCF numbers were up one year and down the next. If you look at 10 years of data though, it was not a rosy picture at all.

CNBC had a special on that discussed Enron. It is worth watching to udnerstand how the books ended up getting cooked. What irks me most though is the part involving politicians.
Atotonilco - 10 years ago    Report SPAM

To be reliable, FCF requires an estimate of the Capex to be spent next year.

In any event, how many companies in our system throw off enough cash flow to pay for all their Capex and dividends. There are very few, which generally makes FCF a negative number.

CFO on the other hand is the real picture of what has transpired during the year, adjusting net income by the adittions or subtractions that result from the fluctuations or net buildup in receivables and inventories. While it can be manipulated in any given year, a five year trend will give you a clear picture of what is going on. In my opinion, CFO is the better guideline.
Rommel Acosta
Rommel Acosta - 10 years ago    Report SPAM
Why subtract dividends when computing FCF? I think it should roughly be cash from operations minus maintenance capex, with adjustments if there are too many non-recurring items.
Sivaram - 10 years ago    Report SPAM

ATOTONILCO: "In any event, how many companies in our system throw off enough cash flow to pay for all their Capex and dividends. There are very few, which generally makes FCF a negative number."

Actually the vast majority of companies should be posting positive FCF or else they are going to go bankrupt eventually.

I tihnk what Rommel says in response to your comment is how it should be done. FCF does not include dividend payments. By definition, FCF = CF from operations minus CAPEX. If FCF is negative it isn't because of dividends but is probalby because the company is spending money on CAPEX to grow the business.

CF from operations is smoother but it can leave out the cost of doing business. If CF from operations is $1 million but it takes $700k in CAPEX to sustain the business, your company is only earning $300k. If you base your valuation on $1m you will get a very rosy picture of the business.
Kfh227 - 10 years ago    Report SPAM
When looking at cap ex, try to understand what is going to happen for hte next 5 years. Also do the same for cash from ops. Projecting one year out accurately is not useful. Being approximately right over the next 5 years is important. Same for 6-10 years out.

If reasonable projections can not be made, do not invest,

Atotonilco - 10 years ago    Report SPAM

Both CFO and FCF are particularly helpful to any analysis.

Most companies make some judicial use of Debt and Equity in funding their operations going forward.

The CFO figure over time certainly has to be positive,or they will go under.

The CFO figure is the addition to the Equity side of the capital structure after allowing for the investment requirements in short term assets.

A company always has to decide upon the payout ratio on dividends, or how much of their profits are going to be paid to the shareholders and how much will be retained on the Equity side of the capital structure..

The portion retained is their annual addition to Equity which supports their addition to Debt.

If a company wishes to keep a 1 to 1 capital structure, then after payouts to shareholders, they will target funding their capex with 50% Debt and 50% Equity.

Thus, the FCF figure in most years for a growing company will normally be negative.

Suppose the CFO is $1 miillion and the company has a payout ratio of 50%..

Assuming CFO parallels closely with earnings, they will pay out half in dividends,($500,000) and have a similar amount available for Capex.

Under a 1 for 1 conservative Debt to Equity structure, this would provide for half the Capex and they would borrow the other half.

So the FCF would be negative and still cover all the dividends and half the Capex.

Of course any company which can cover all dividend payout and 100% of Capex, would never need to borrow. In some cash rich companies where this occurs, you often see that they have a policy of borrowing to do share buybacks.

Their liquidity is in such good shape that they are making judicious use of Debt to add to shareholder value, to buy back shares, even though they do not need to borrow.
Sivaram - 10 years ago    Report SPAM

ATOTONILCO: "Their liquidity is in such good shape that they are making judicious use of Debt to add to shareholder value, to buy back shares, even though they do not need to borrow."

Growing companies do tend to have negative FCF. They also usually don't issue dividends. But it is unsustainable to rely on debt financing. Not tomorrow or next year, but eventually they need to produce positive cash flow. Leveraging up has its limits.

Coming back to the original discussion, operating cash flow may provide some insight about the nature of business but I'm not sure how you can use that in valuing a company. One needs to factor in CAPEX (i.e. FCF, not CF from operations) because the benefit that accrues to shareholders resembles the FCF and not the CF from operations.
Atotonilco - 10 years ago    Report SPAM
Never referred to overuse of debt. Also stated that FCF and CFO are both useful..

However on average, FCF is not usually positive because companies do not and cannot always fund their Capex with Equity.alone.
Adib Motiwala
Adib Motiwala - 10 years ago    Report SPAM
I use

Cash Flow = Cash from Operations

FCF = Cash from operations - Capex.

( To be more accurate you have to find out maintenance capex from growth capex and only subtract maintenance capex. However, since this determination is not always easy to make, taking the entire capex is the conservative thing to do).

In terms of valuation, I look at Price/FCF along with EV/ CF. Remember, P/FCF does not account for leverage, just like ROE can appear large due to the use of high leverage. Using enterprise value (EV) allows you to look at see a multiple of cash flow at the enterprise level.

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