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Beyond the Bottom Line: Why Free Cash Flow Trumps Earnings for Investing Success

There are many items in finance and investing that people accept without questions. Two of those items are the utility of both analyst estimates and earnings. To be fair, there are a good number of people in the world that have come to ignore both analyst estimates and quarterly earnings. There is a good chance those are the same people that don’t see the utility in standardized tests as well.

The Securities and Exchange Comission requires all companies to provide financial disclosures. Quarterly disclosures must come at the end of each company’s first three fiscal quarters. At the end of the fourth quarter, companies must report annual and quarterly results. These financial disclosures are called ‘earnings reports.’ There are some (I’m one) that thinks quarterly reporting is a little too much.

To make the whole thing more onerous, there are third party analysts that estimate what companies will report. The heavens come crashing down if a company does not hit the collective, analyst estimates. For long-term investors the quarterly reports are more noise and very little signal. The analyst estimates are part of the noise as well.

The cherry on top is that the earnings reports focus on the flawed data point called ‘earnings.’ In fact, the earnings that are being referred to is actual the company’s net income or profit.

Net income is revenue minus
cost of goods sold
selling and general expenses
administrative expenses
operating expenses
depreciation
interest
taxes

The problem with assessing a company’s performance by earnings is that there is too much room for funny business in earnings. It is so widely accepted that companies fudge their earnings numbers that is has an actual name – earnings management.

For example, a retailer switches accounting policies from LIFO (Last in First out) to FIFO (First in First out) for sales from inventory. This slight election can result in higher reported profits as FIFO can lower costs of goods sold.

Further, many company executive pay programs are linked to earnings. So, there is a huge incentive to make earnings numbers look better than they may actually be.

More important than the above shortcomings is that quarterly disclosures tell too short of a story. Consider the following quote from the Harvard Business Review.

But for all the attention paid to the quarterly earnings number, it’s not much use in predicting a company’s future performance and future cash flows—which are, theoretically anyway, the basis for determining the value of a share of stock. Academic economists who disagree about nearly everything else are unanimous in their view that the quarterly earnings report says next to nothing about a company’s prospects beyond the next quarter—and even over such a short time horizon, the report’s predictive value is severely limited.

Nonetheless, quarterly earnings have become a sort of talisman for corporations and those who analyze them, invest in them, or audit them. The fetishistic attention to an almost meaningless indicator might be cause for nothing more than amusement, except for one thing: the earnings game does actual harm. It distorts corporate decision making. It reduces securities analysis and investing to a guessing contest. It compromises the integrity of corporate audits. Ultimately, it undermines the capital markets.

HBV 2001 – The Earnings Game: Everyone Plays, Nobody Wins

Honestly, I could not have written it better than HBV.

So, what can we look at instead of earnings?

1. Earnings Growth

Well, for one, according to the founder of The Investors Business Daily, William O’Neil, the answer is earnings growth. Said otherwise, pay more attention to the the rate of growth in earnings than the actual number itself. To O’Neil, looking at the recent few quarter earnings growth was more predictive of price performance in the short-term.

While we are tearing down earnings as a useful indicator let’s make it clear that the price to earnings (PE or P/E) ratio is just as flawed. Why, you might ask? The answer is that earnings are the denominator in the ratio. If earnings are flawed then so is PE.

2. Free Cash Flow

In simple terms, free cash flow (FcF) is the money left over after a company pays for everyday operating expenses and capital expenditures. More specifically, FcF is money that can be used to pay dividends, retire debt or grow the business.

When FcF is growing it’s often followed by increased earnings. When a company has growing FcF due to anything from revenue growth to share buy backs to debt reduction they can reward shareholders later. Keep in mind that no metric is perfect.

The Pros of FcF are:

  • Window into health of company
  • Shows company can pay debts
  • Can point to future growth

Cons:

  • FcF can vary by year based on CAPEX spending
  • High FcF can mean there is a lack of investment in assets, research etc…

FcF is not a line item on a financial statement. So, it must be calculated using information provided on financial statements. I calculate FcF for every company I analyze.

If you’ve been following along you might have guessed that we can replace the PE ratio with a FcF based ratio. This is commonly referred to as the Free Cash Flow Ratio. The formula is:

Free Cash Flow Ratio = Market capitalization / Free Cash Flow

This is a great replacement for the PE ratio. The free cash flow ratio (P/FcF) can tell whether a company is under or overvalued based on free cash flow. The higher the ratio the more expensive the stock is on a free cash flow basis. Said otherwise, the ratio tells you how many times the company’s free cash flow that the stock is trading at. A higher ratio means you are paying more for the free cash flow being generated by the company.

The bottom line of this post is that you can ignore the noise of earnings reports, earnings estimates and PE ratios. Instead, look at the trajectory of earnings reports, focus on free cash flow and free cash flow ratios.

Good luck out there.

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