Cash Flow Is King
At last week’s MoneyShow in Orlando, I addressed Chevron’s (NYSE: CVX) recent non-cash impairment, and the impact this had on earnings. What I told the crowd was that what is really important is cash flow. I saw several people nod their heads, and others take notes. So I thought this might be a good opportunity to review cash flow, and why it’s a more important metric than earnings.
What Is Free Cash Flow?
Free cash flow (FCF) measures cash generated by a company in excess of its spending, including capital expenditures.
This number is calculated by starting from net income, adding back depreciation and amortization (because those non-cash costs relate to historical expenditures), adjusting for certain non-cash impairments (those impairments are applied against net income but not cash flow) and then subtracting interest paid, changes in working capital and capex.
This is a more accurate and comprehensive definition of cash flow than the one used by many, which is simply cash generated from operations minus capital expenditures. But it really boils down to the cash revenues that come in, and the spending that goes out.
The reason this is a better metric than earnings is that earnings can be manipulated, and don’t really give a good indication of how much cash a company is generating.
For example, in the previously-mentioned case of Chevron, the company reported earnings of $2.9 billion in 2019. That was down nearly $12 billion from 2018, and was primarily driven by a large non-cash impairment to Chevron’s oil and gas properties.
However, Chevron reported 2019 FCF of $13.1 billion versus 2018’s result of $16.9 billion. The result was lower due to lower commodity prices, but that’s still a lot of positive cash flow that Chevron can use to invest in its business and pay dividends to investors.
But if one focused only on earnings, you would get a misleading picture of Chevron’s financial position.
Who Generates The Most Cash Flow
Which companies generate the most cash flow? I recently ran a screen to determine the world’s largest publicly traded FCF generators. The following table summarizes the results:
Unsurprisingly, many of the biggest generators of FCF are companies whose products we use on a daily basis. Apple (NSDQ: AAPL) generated $64 billion of FCF, with Microsoft (NYSE: MSFT) in second place.
Royal Dutch Shell (NYSE: RDS.B) was the highest-ranking oil company on the list. Shell was #11 according to this ranking with $19.2 billion of FCF. Chevron’s $13.1 billion landed them in the 25th spot.
Of course a company’s FCF relative to its size is also worth considering. Apple’s $64 billion of FCF translates to FCF per share of $14.36 and a FCF yield of 5.0%. In comparison, Amazon’s (NSDQ: AMZN) FCF yield was 2.3%, but Shell’s was 6.7%.
Companies that consistently generate solid FCF are unlikely to go broke. Income investors should look at whether a company is growing its FCF, because that’s a good indicator that they can grow dividends over time.
The bottom line is that FCF is a crucial financial metric and a good check against a company’s earnings reports. If a company is reporting great earnings but negative cash flow, or vice versa, you definitely want to take a closer look at what’s really going on.
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