Cash Is King: Why Cash Flow is More Important than Earnings
While many investors focus on a company’s earnings per share (EPS), there are other metrics that may be more indicative of a company’s prospects for growth. That’s because EPS can be easily manipulated and isn’t always an accurate representation of how much cash a business has at its disposal; management can game when certain expenses and revenue are recognized in addition to the myriad other accounting gimmicks that can be employed to artificially inflate EPS. In short, earnings don’t automatically translate into liquidity.
So while EPS remains one of the most popular measures of a company’s performance, it’s not necessarily the best. Companies can produce staggering EPS one quarter and go broke the next—think Enron—but companies that produce consistently high and growing levels of free cash flow (FCF) are unlikely to go bust any time soon. And with some types of securities, such as master limited partnerships (MLP) and real estate investment trusts (REIT), EPS can be completely uninformative because of the unique accounting required for these types of entities.
FCF is a measure of the unencumbered cash a company generates after it meets the necessary expenses of its operations and invests in its future growth. FCF is a key metric because it’s a much more accurate measure of how much cash a business actually has to service debt, pay dividends, invest in its operations or buy back shares.
At the most basic level, FCF can be calculated as operating cash flow minus capital expenditures. For a more fine-tuned measure, add any non-cash adjustments for depreciation and amortization back to net income, and then subtract any change in working capital and capital expenditure to arrive at the correct figure. From there, FCF can be calculated per share by simply dividing FCF by the weighted average of a company’s shares outstanding. All the data necessary to perform these calculations can be found on a company’s balance sheet and income statement.
FCF is an important metric regardless of whether an investor is interested in capital appreciation or income. For growth-oriented investors, companies with high FCF are likely to deploy that excess cash for the capital expenditures necessary to grow their business. And rising levels of FCF are generally an excellent indicator of future earnings gains. For income investors, FCF is a reliable indicator of a company’s ability to maintain its dividend or even increase its payout.
One caveat, however, is that FCF sometimes requires an additional layer of analysis. For example, some companies may consistently generate high FCF, but suddenly suffer a quarter in which FCF is negative. In such cases, an investor should determine whether the drop in FCF was due to cash being directed toward internal investment, which can be a good thing, or a sharp decrease in revenue. If the dip can be explained, it may not be a red flag unless FCF consistently drops over subsequent quarters for no particularly good reason.
Cash flow isn’t always a foolproof investment metric, but companies with high FCF should always have enough cash to pay the bills and grow their business. If nothing else, paying attention to cash flow will help you avoid most bad investments.