Cashflows question

[BadBoyBenny]

Thanks for the post Bob, it should lead to some good discussion.

I agree with most everything Adios has already said (I usually do). I would point out that the investor has to be real careful about a company’s interest expenses and liquidity if looking at EBITDA to value a company.

I have been in past posts one of those people who says they like cash flow numbers better than earnings.

However, anyone using earning or cash flow to value a stock without taking a long look at the balance sheet is just plain ignorant.

I need to make an important distinction here that I should have made in previous posts. When I talk about valuing cash flow over earnings I mean either Operating Cash Flow (OCF) or Free Cash Flow (FCF), depending on the situation. These are both a different concept than plain old cash flow and also very different from each other. I will try to be more specific in the future. If you don’t already know how to define both, you probably have no business investing in individual companies; unless of course you are into technical analysis which I don’t have much trust in.

As an accountant (or soon to be) I’m sure you know this but for other newbie’s sake I’ll give a quick definition to both.

OCF is a company’s cash from operations and excludes financing activities. It describes a company’s ability to either return money to shareholders, or expand the business through capital expenditures (like buying large machines, building new stores, etc.).

FCF is OCF minus capital expenditures and is a pretty good representation of a company’s ability to pay down debt, or return money to shareholders by paying a dividend or buying back shares. Maybe it could be used for acquisitions as well.

A reason I usually look at cash flows as a better indicator, is because posted EPS numbers, and earnings are often pro forma. Many investors (poor ones) use EPS figures from trading or finance sites that are based on a company’s pro forma numbers. Pro forma numbers to me are usually bullshit. I see twenty one-time losses excluded from pro forma numbers for every one-time gain that is excluded. This helps me identify a better “short list” when using stock screeners and making quick evaluations of companies to further investigate. I would never rely on any one number of any kind from any source as a reason to buy a stock without doing due diligence and reading the last 3 year’s 10K’s and the last 4 quarter’s 10Q’s, and doing a further study of the financial statements and management discussion contained therein. Another reason I like cash flows is that PE’s are often calculated using estimated future earnings, while P/FCF ratios are often estimated using Trailing Twelve Month numbers. So you get a more conservative estimate.

There are 2 situations I can think of off the top of my head where cash flows outpacing earnings indicate a strong business model and management that can maximize the value of their operations.

1.) Good management of payables and receivables leading to excess float that the company can use as working capital. This lets them return more money to capex or the shareholders.

2.) Earnings that are hampered by depreciation on expenditures initially funded by debt that has now been paid off. This is also true if the debt is partially paid off and is at a reasonable level of leverage and interest.