Cash Flow Verses Earnings

Follow the Cash Flow to True Profits

Cash Flow Vs Earnings – Cash Flow is the true measure of a company’s profitability. It is determined by the net change in cash that enters or leaves a company in a given period. The focus on cash flow rather than earnings is what most distinguishes MarketBeaters from other services offering investment advice. Typically, institutional and individual investors value stocks based on earnings per share and the popular “PE” ratio. This is an inaccurate measure of a company’s true profitability as will be shown below. The main reason for this is the tremendous amount of leeway a company has in calculating its earnings.

The earnings figures that companies are required to report every quarter do not show a company’s true profitability. Unfortunately for the individual investor, today’s GAAP (Generally Accepted Accounting Principles) accounting methods allow a company to report an inflated version of their real profits. These methods often confuse individual investors and prevent them from gaining any real insight into the numbers.  They are left to focus on a single earnings per share number which can vary from company to company based on their interpretations of GAAP.

Below are some of our favorite examples of how companies puff up their numbers:

  • Companies can set up reserves to cover the costs of non-recurring events such as restructuring. These reserves are often called cookie jars and are over-inflated by management because any cash left over after the restructuring can be counted as earnings although it has nothing to do with their operational business results.
  • Companies can take a special one time write down if they mismanage their inventory. They can take an immediate “non-recurring” charge to earnings rather than allow the excess inventory to reduce their profitability over the coming quarters as it is sold below cost due to overcapacity in the market.
  • Companies are allowed to spread the cost of capital intensive equipment and buildings out over the expected lifetime of the item. The specific time amount is up to the company’s discretion so it is possible to make earnings look better in the short term by choosing a longer than necessary depreciation schedule.
  • Companies can inflate their earnings simply by claiming that they expect to make more money in their pension funds than previously expected. Their rational for doing so is if the fund grows at a higher growth rate, then less money needs to be invested in the short term to obtain the desired future level. The problem is the raised expectations may never be achieved. In addition, accounting rules allow companies to smooth their pension assets over a 5 year period. As a result IBM, which assumes an annual 10% future return, reported a $4.2 Billion profit from its pension fund in 2001 even though the fund really lost $2.4 Billion. Similarly, Verizon with an expected 9.5% return, reported a $1.85B gain while losing $3.1B in the same year
  • Companies often take large charges that they classify as non-recurring and exclude them from their earnings. For many companies, these write-off’s for non-recurring events actually occur quite frequently. For example, Cisco, Compaq, and Waste Management’s 5 year average earnings ending in 2002 without these write-off’s would be reduced by 32%, 76%, and 82% respectively.
  • Companies, without real earnings will often try to pitch its pro-forma earnings which exclude nonrecurring charges that cost shareholders real money. Pro Forma results are used to show earnings that might have been achieved if a recent merger or acquisition had occurred at the beginning of a reporting period.
  • Telecom companies often trade capacity with other providers in barter deals. In these deals, a company will record capacity it sells as revenue and record the capacity it buys as a capital expenditure, allowing them to amortize the expense over many quarters. This is a way to inflate both revenue and earnings. Global Crossing was the worst offender with nearly 20% of its revenue derived in this way before going through a bankruptcy in recent years.
  • Until recently, companies were allowed to exclude the cost of stock options. Stock options devalue the stock by diluting shares. Cisco would have earned $1.6 billion instead of the $2.7 billion it reported in FY2000 if it included the effects of stock options. Yahoo would have lost $1.3 billion rather than its reported $71 million in earnings for 2001. Perkin Elmer’s 2001 .33 EPS would go to a penny per share and Charles Schwab’s .14 would go to 2 cents per share. Gateway’s .76 per share reported earnings in 2000 would have been a loss of .14 per share. For the period from 1996-2000 Lucent would have earned only $1.3 billion rather than its reported $6.2 billion if it wasn’t allowed to employ the pension fund and options tricks mentioned above. This would have given many investors advanced warning of its demise in 2001.

These types of accounting shenanigans can make a company appear much healthier than it really is. The disastrous corporate scandals that occurred in recent years have finally brought it to America’s attention that we need a standard definition of earnings. Until this happens, there is no accurate way to compare the value of stocks based on PE ratios.

Companies want you to focus on earnings because, unlike cash flow, they have the ability to manipulate (often referred to as “managing”) earnings to produce consistent results every quarter. The problem with paying for managed earnings is you don’t know when the last rabbit will be pulled out of the hat. Sooner or later the company will run out of accounting tricks. When it does happen you can expect a large drop in the stock price when the earnings are reported.

At MarketBeaters we measure a company’s profitability based on cash flow because it provides a clearer picture of the company’s results than earnings do. Cash flow is the net cash coming into or leaving a company. All publicly traded companies are required to report financial results every quarter. Cash flow information can be found on the company’s 10Q in the Statement of Cash Flows which companies have had to report since 1987. This statement is often overlooked in favor of the Income Statement on which earnings are reported. Cash flow investors know the truth is on the Statement of Cash Flows however. The cash flow statement is prepared in a similar way as balancing your check book registry and thus makes it much harder to manipulate than earnings.

If you examine the Statement of Cash Flows, you will find cash flow broken down into the 3 areas of Operating Activities, Investing Activities, and Financing Activities. Cash Flow from Operating Activities represents all of the cash that was generated/lost from the company’s business operations (sales of goods & services, purchase of raw materials, payment of taxes, etc.). Cash Flow from Investing Activities represents the net cash generated/lost from investments (purchase/sale of bonds, buildings, equipment, etc.). Cash Flow from Financing Activities represents net cash generated/lost from financial activities (proceeds from issuing stock, payment of dividends, payment of debts, etc.).

We focus on Cash Flow from Operating Activities because it is the real wealth creation engine of a company. The cash it generates from its business operations is what will drive its future growth. By focusing on Cash Flows from Operating Activities we can screen out cash flows generated by selling property, issuing bonds, capital gains, or any other non-business related methods. Generating cash from non-business related activities is not necessarily bad, but is not a factor in valuing the future profit potential of the company.