Both earnings per share and cash flow per share give investors an idea of how a company is doing. Many investors value stocks focusing upon earnings per share and the popular Price to Earnings ratio (PE). Often times, however, the earnings figure alone does not reveal a company’s real profit levels because there is tremendous leeway in reporting earnings, which can manipulate and smooth earnings, potentially distorting a company’s true intrinsic value.
Earnings are subject to numerous esoteric accounting rules, many of which can reduce or inflate reported earnings. A prime example is pension accounting where a company can estimate a greater future expected return on investments in order to minimize today’s impact on profitability. The actuarial return assumption is subjective, non-cash, and therefore vulnerable to abuse which can lead to overestimations of profitability and true intrinsic value.
Simply put, reported earnings represent sales made and billed for, while cash flow reflects earnings as they are paid. As an owner of a business, you want to know what the cash flow is on the business in terms of what you’ve been paid because ultimately that is all you can withdraw as an owner to earn a return on your capital, aside from an outright sale. There is no difference between a public company with thousands of shareholders and a single shareholder lemonade stand other than the public shareholder interest can be sold with the click of a mouse typically. The mindset should be the same, which is to think as a business owner.
We’ve established that cash flow represents the true measure of a company’s profitability determined by the net change in cash that enters or leaves a company in a given period, but in terms of how cash flow is reported on financial statements, it is broken down into three parts:
- Operating flows- cash generated from operations.
- Investing flows- the net result of capex, investments and acquisitions.
- Financing flows- cash changes resulting from financing activity such as equity or debt issuance.
Cash flow from operations (CFO) and ultimately free cash flow (CFO minus maintenance cap-ex) represent the real wealth creation of the company, in our view. By focusing on cash from operations and drilling down to free cash flow you can better analyze what levels of recurring cash are generated by the business to drive future growth.
Cash flow may require an additional layer of analysis if a company has an erratic change; sometimes the cash can be directed towards an internal investment or a company may experience a sharp decrease in revenue or cash collection from customers. Erratic patterns of cash from operations can be indicative of financial distress or an inconsistent business model. While it is not fail-safe, cash flow analysis is a powerful investment metric to monitor, particularly when it comes to whether a company has the ability to fund capital expenditures to grow its business, sustain and grow dividends or buy back stock in order to create value for shareholders.
Sonia Mintun, CFA, is a Director, Portfolio Manager at Ancora Advisor LLC a SEC Registered Investment Advisor. She is also a Registered Representative of Safeguard Securities, Inc. (Member FINRA/SIPC)
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