In this 12-part Cadence Investing Series, we discuss several aspects of the investment process and how it actually works in practice. Topics covered include market psychology and fundamental analysis, and aim to provide the reader with a first-hand view of how financial theory stacks up in real world situations.
In our seven preceding articles in the Cadence Investing Series, we have discussed the psychology of the market, as well as a number of fundamental measures commonly used by the investment industry.
This article discusses cash flow, which in our opinion, is the most important of all the fundamental measures. We will discuss operating cash flow and free cash flow separately.
Operating cash flow
Operating cash flow measures the amount of cash a company generates from its daily operations. This can be very different to the profit a company generates.
A company may sell many products in a year and offer credit to customers to buy those products, which they have purchased from suppliers. While this strategy may deliver a good profit, it does not produce any operating cash flow.
In fact, in this example the operating cash flow would be negative. The company has paid cash for goods but not received any cash in return yet.
A property trust may buy properties with debt and rent them out to tenants at yields lower than the interest rates on debt, then subsequently revalue the properties upwards by, say, 10 per cent, thus producing a “healthy” profit.
The property trust in this example would in fact produce a negative operating cash flow. Rent received would be lower than interest paid and the property revaluation produces no cash.
You often hear investors say “cash is king,” and in the end, cash is king. If a business does not produce cash flow then there is a good chance it will not be around in the long run. This is why we pay particular attention to big differences in reported profits and reported operating cash flows.
One of the most useful things all of our portfolio managers do is to reconcile profit to operating cash flows. This process can help prevent large investment errors.
At a basic level, the process of reconciling cash flows to profits involves a closer look at revenues, expenses, debtors, creditors and inventory, or stock in hand. Large discrepancies in these numbers can often spell trouble, or at the very least, they need to be carefully explained by management.
Free cash flow
Free cash flow is derived from the operating cash flow outlined above and then takes into account major expenditures on, for example, property, plant and equipment, the purchase or sale of a business and major expenditure on maintaining or growing business assets.
The distinction here is that even though a business may produce good operating cash flows from its daily operations, the cost of maintaining or buying new equipment, say, every five years, may actually turn a business with good operating cash flows into a business that loses money at the free cash flow line.
Conversely, a business that makes only moderate operating cash flows but employs little to no capital in making those operating cash flows may actually produce an acceptable free cash flow.
It is important to understand whether the big capital investments made to generate an operating cash flow actually exceed that cash flow or provide sufficient return to justify the capital investment.
How does operating and free cash flow help us?
It is all very well making the effort to establish the operating and free cash flow for a business, but what do you then do with this information?
It is fair to say that different investors use this information in different ways, and in times of euphoria it could also be argued that some investors tend not to trouble themselves with cash-flow numbers.
We take the operating cash flow of a business and divide it by the market capitalisation of the company to get a “proxy” for operating cash flow yield as a percentage, for example, 12 per cent operating cash flow yield.
Similarly, with free cash flow, we take free cash flow for a business and divide it by the market capitalisation of that company to get a proxy for free cash flow yield, for example, 10 per cent free cash flow yield.
These two measures give a simple percentage return for a company you may invest in. There are much more complicated measures, such as return on equity, return on investment and return on incremental investment.
In our daily modelling of companies, we find that operating and free cash flow yield measures are usually more than enough to determine whether a company offers compelling value from a return on cash flow perspective, without the added complexity of other measures.
We would argue that of all the fundamental measures we undertake, these two cash-flow measures are the most important. While slightly more complicated to calculate than the fundamental measures we have written about to date, they are well worth mastering.
Many investment books cover the basics of calculating cash flows and all basic accounting courses would cover this area of analysis.
A good understanding of cash-flow multiples has the added benefit of keeping investors out of trouble when it comes to companies with inflated or fabricated profits, which do not translate into cash flows. It is much more difficult, if not impossible, to easily manipulate cash flows.
Keen followers of corporate collapses may have seen the film Enron: The Smartest Guys in the Room. While very entertaining, one of the astounding things that came out of the film for me was that providing investors with balance sheets and cash-flow statements in the United States was not compulsory at the time of the Enron collapse.
As a result, Enron management found it much easier to manipulate profits by booking, for example, the next 20 years of profits in the current reporting year!
Had investors been provided with a cash-flow statement or balance sheet, it would have been clear that profits did not match cash flow as clients clearly had not prepaid revenue 20 years in advance!
Incidentally, as a consequence of Enron-style collapses, the United States has now made it compulsory for US companies to provide a cash-flow statement and balance sheet — a requirement that has always existed for Australian-listed stocks.
Since we have the benefit of a cash-flow statement and balance sheet in Australia we should use it. Our next article will take a brief look at company balance sheets.
If you enjoyed part eight of the Cadence Investing Series keep an eye out for our weekly articles, eBooks and 56 Books To Read Before Buying Your First Stock.