What’s more important than profits? Well of course family, friends and health, but what about in a business? My favorite valuation measure is actually cash flow. Everyone has heard the saying that “cash is king.” At today’s interest rates I would argue that cash is a waste of money, but cash flow is king!
Most market participants look at profits, with the most widely monitored metric being the price-to-earnings ratio. This is an important metric but more easily dressed up by corporate management looking to impress investors. It is also encumbered by tax and regulatory rules. Even Warren Buffett, in his company’s 2017 annual report, bemoans a recent new U.S. tax rule that he says will “severely distort Berkshire’s net income figures.” This is from a guy widely respected for his frank and honest portrayal of company financials. Lots of accounting quirks muddy the profit picture, which can make it difficult to evaluate a company.
Cash flow on the other hand is a simpler measurement. It is cash generated minus cash spent. It is much more difficult for corporate management to distort the cash flow picture. Capital intensive businesses, like farming, can actually be very successful with minimal profits, as long as they generate good cash flows. As a comedic farmer once remarked, “look at my combines and tractors… all paid for with losses.”
One difference between cash flow and profits is cash flow doesn’t include non-cash costs like depreciation, nor unusual write-downs or write-ups of asset values, as recently occurred in the U.S. due to tax changes. This metric is called “operating cash flow.” There is another cash flow measure called “free cash flow,” which takes operating cash flow and subtracts capital investment. Let’s say a company had $100 of revenue and had cash expenses of $60, its operating cash flow would be $40. If it also spent $20 on a capital expense like a building, it would then have free cash flow of $20. Its bank account would have to be $20 greater at the end of the year, than the beginning. Bottom line: cash flow has proven to be a reliable and consistent measure of corporate success.
For clarification, I am neither an accountant nor a professional financial analyst, just someone who has been able to make above average returns investing in stocks. Keeping it simple, the main criteria I look at are cash flow yield, earnings yield and dividend yield, as well as long-term growth rates of these items. All were outlined in the “Titanium-Strength Model TFSA Portfolio” of my previous column. Please take note of how similar the average 10-year dividend growth, profit growth and cash flow growth were. While varying from company to company, the trend is evident having more than doubled on average.
Another simplification is to use “earnings yield” and “cash flow yield,” rather than the price-to-earnings (p/e) and price-to-cash flow (p/cf) used in the financial industry. Earnings yield is the inverse of p/e, but earnings yield is easily understood as it equates to interest rates, which we all understand.
If a company earned $5 per share and had a share value of $100, then the earnings yield would be $5/$100 x 100 (to get to a per cent) = five per cent; just like five per cent interest (ya right eh!). That means you earn $5 interest per $100 invested. The p/e would be $100/$5 = 20 which doesn’t compare easily to interest rates. Using earnings yield makes it easier to compare returns across investment types. I much prefer the average 3.1 per cent dividend yield, 5.9 per cent earnings yield and 9.4 per cent cash flow yield to current interest rates.
My book includes a more complete but still simple explanation of financial metrics.