Cash Flow: One of the Most Accurate Ways to Analyze a Stock’s Value
by Marc Lichtenfeld, Advisory Panelist
Wednesday, June 23, 2010: Issue #1287
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 because earnings 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: Operating cash flow minus capital expenditures. |
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. (NYSE: 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 (NYSE: 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 its dividend 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
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11 Responses to “Cash Flow: One of the Most Accurate Ways to Analyze a Stock’s Value”
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Marc Lichtenfeld is embedded in the biotechnology and healthcare sectors. As Healthcare Specialist for The White Cap Research Group, his days are spent tracking the clinical trials of various companies seeking FDA approval on pharmaceuticals, which oftentimes means interacting with CEOs of companies.
June 23rd, 2010 at 12:01 pm
Any info on ComexOnLine?
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June 23rd, 2010 at 12:20 pm
How do you get the p/cf ratio. Dr Pepper price is 37.35, operating cash flow is 865 Mil, free cash flow is 540 Mil. No ratio using those numbers results in approximately 6.
Thanks
Reply
Investment U Reply:
June 23rd, 2010 at 1:44 pm
Gunter,
Free cash flow for the trailing twelve months was $1.4 billion, which gives us a P/CF ratio of about 6. Please note that the definition of free cash flow published earlier in the day was incorrect. The definition of free cash flow is cash flow from operations minus capital expenditures.
Thank you,
Marc & Investment U
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June 23rd, 2010 at 2:52 pm
you made it so simple yet people don’t follow. It makes perfect sense to use CF as a yard stick to evaluate a stock. Please do keep writing such article.
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June 23rd, 2010 at 3:03 pm
I still don’t get it. $37.00/1,400,000,000 unequal 6.
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Investment U Reply:
June 24th, 2010 at 9:08 am
Robert,
P/E is easily calculated as it’s the price of the stock divided by the earnings per share. Cash flow is often reported as the full number, not per share. So instead of the price of the stock you take the market cap (price x # of shares outstanding) and divide it by the cash flow. In DPS’ case, the market cap is $9.1 billion. Cash flow is $1.4 billion. 9.1/1.4 = 6.5
You could also divide the cash flow by number of shares outstanding to get a cash flow per share figure and then calculate P/CF the same way you’d calculate P/E, just replacing the earnings per share with cash flow per share.
Thank you,
Marc & Investment U
Reply
Khalid Radwan Reply:
June 26th, 2010 at 1:57 am
That’s great, but wasn’t GFA a company Alexander Green recommended in his New Frontier Trader? At the time the stock was around $34, today it’s $13.
Did Mr. Green not examine the CF of GFA like you did Marc or is the price decline attributed to other factors?
Khalid
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June 23rd, 2010 at 8:52 pm
Thanks for the educational article. I always wondered about the cash flow ratio rule of thumb.
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June 23rd, 2010 at 10:41 pm
I think this is a great article but it did not offer how to find a P/CF value for a stock. Are they published like the P/E values are?
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Investment U Reply:
June 24th, 2010 at 9:09 am
Harry,
Please see the response to #4 for how to calculate P/CF. Most financial websites do not publish P/CF for some reason. Morningstar is one that does.
Thank you,
Marc & Investment U
Reply
June 28th, 2010 at 7:56 am
Thanks. For quite some time I am getting ur valued letter.This article has given me good education to evaluate my portfolio. Most of the companies u mention cannot be accessed/used as self being in India. However this – CFP Ratio is universal and it will give me full opportunity to weed out or add in my portfolio some bad/good companies. Thanks for this education.
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