Investing 101: Earnings Vs. Free Cash Flow

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Jan 25, 12 Investing 101: Earnings Vs. Free Cash Flow

Editor’s Note: Daniel Sparks is a guest blogger at Vuru and is a US Army veteran and MBA student at Colorado State University. He has a passion for value investing and runs a value investing blog at ValueFolio. It’s part of an Investing 101 series.

It’s earnings season again. Once again we see the headlines rolling out: “Company X misses estimates . . . Company Y obliterates estimates.” Earnings (or income) is Wall Street’s most beloved number. Stocks often move up or down double digits simply because a certain number was reported on earnings day. With all this earnings hype we need to make sure that we are wearing lenses that can help us see past it.

How relevant is reported income to stock analysis?

Let’s first answer this vague question with a vague answer. Then we’ll explore deeper. In the short-term (quarterly), reported income can often be completely useless. However, over a period of 5 – 10 years we could probably discover some things about the business model and how management allocates capital by looking at earnings trends and profit margins. This is because, from quarter to quarter, earnings can be easily manipulated because of the accrual accounting method from which it is derived. Welcome to Investing 101.

What is accrual accounting?

Accrual accounting was derived to give stakeholders a more accurate picture of a company by recognizing economic events even when a cash transaction does not actually occur. The main idea behind accrual accounting was “matching.” The aim of “matching” is basically to match the appropriate costs and expenses with the specific revenue that resulted from those costs and expenses.

For example, if a manufacturing business purchases an operating plant in January but derives economic benefits from the plant for the next 12 months then accrual accounting theory says the cost of the plant should be spread out during its useful life for which it provided economic benefits to the business entity, even if the cash transaction was made in January.

In theory it sounds great, and over a 5-10 year period the income statement can be very helpful. But looking at a quarterly income statement to decide exactly where a company is today can be quite deceiving.

What is the problem with earnings?

There are really 2 major problems with earnings (income) and accrual accounting:

1.    The GAAP rules guiding accrual accounting are very vague, allowing for drastic differences in the way companies report accounting. Sadly, because of this vagueness, there are really two types of ways for companies to report their income: (1) aggressively or (2) conservatively. Aggressive companies like to hike up their earnings for one reason or another. They take advantage of the vague rules guiding accrual accounting to make it seem as if they are more profitable than they really are. This is a terrible practice because it is a short-term focus and because the more income a company reports the more taxes a company has to pay. On the other hand, companies who use conservative methods to report income are doing what is best for shareholders. This means they are keeping reported earnings as low as possible, paying less tax, and focusing on the long-term.

2.    It is difficult to analyze the financial health and profitability of a business through a company’s income statement. Because of this vagueness in the guiding principles of GAAP for accrual accounting, it’s not easy for a stakeholder to develop an accurate financial picture of a company unless they have a very good understanding of a company’s financial reporting methods. In other words, the numbers reported on the income statement can easily fool the beginner investor.

What is the alternative?

Free Cash Flow Definition PictureThankfully, because of the uncertainty behind accrual accounting, GAAP rules require a cash flow statement. The beauty of the cash flow statement is that cash is not as easily manipulated. Every reporting period a company has to report to shareholders exactly where the cash is going. It’s very important to be able to read the cash flow statement because it is possible for a company to be profitable but not solvent. Investors could have easily avoided the Enron loss if they had been keeping an eye on the free cash flow. For years Enron was not free cash flow positive, yet investors simply could not take their eyes off of the soaring, manipulated earnings. There are plenty of ways to interpret the items on the cash flow statement that can be helpful to your analysis but let’s consider two very helpful methods:

1.    Free Cash Flow (FCF). Free Cash Flow is not an item on the balance sheet but it can easily be found by subtracting capital expenditures from cash flow from operations. This will help you get an idea how much money a business is generating after the expenses of its operations and the costs of its capital expenditures. However, capital expenditures can be drastically higher in one quarter than another so if the capital expenditure is unusually high or low you might want to take some sort of average. Whether it’s a 5-year, 3-year, or 1-year average are all going to depend on the company. For a slow growing company like McDonalds (MCD) for example, you might want to take a 5 or 3 year average. On the other hand, for a fast growing company like Qlik Technologies (QLIK) you might want to use a 1-year average. Whatever you’re using, free cash flow is going to give you a better idea of a company’s profitability and financial health than earnings. Managers that produce free cash flow for shareholders are producing cash that can be used on things that create shareholder value, like buying back shares, investing further in the business, and paying out dividends. free cash flow is used in stock analysis and valuation at Vuru.co. Also, the free cash flow numbers are calculated for you and laid out plainly in Morningstar’s easy-to-read financial statements.

2.    Owner Earnings. For small companies, FCF is usually not relevant because it includes items that are relatively small as a proportion of cash for large companies and can have drastic affects on cash flow for small companies. So when you are looking at small businesses it is better to use Owner Earnings instead of FCF. Owner earnings is a bit more complicated, but it’s only addition and subtraction: Owner Earnings = Net Income + Depreciation + Amortization + non-cash charges – AVERAGE capital expenditures. If this confuses you, simply get a copy of OSV Valuation Spreadsheets. You’ll be able to easily look at Owner Earnings trends and FCF trends over a 10-year period. This is extremely useful. And with Owner Earnings already done, the spreadsheet can easily calculate other useful numbers like Cash Return on Invested Capital (CROIC).

What numbers or ratios are your version of Wall Street’s beloved earnings? What numbers are ratios do you consider most important on the financial statements? Do you rely heavily on earnings like Wall Street does?

Hope you’ve enjoyed this Investing 101 installment.