Look at This Simple Number to Help Pick the Best Stocks

As a child, did you ever read about – and then make your own – pinhole cameras? (I’m pretty sure there were directions in “The American Boy’s Handy Book,” along with do-it-yourself taxidermy and rabbit traps.)

It’s simple to do, and as a kid, it feels a lot like magic…

All you have to do is go into a very dark room on a very bright day, and then introduce light into the room through one tiny pinhole in a curtain.

There, reflected on the opposite wall, you’ll see the outside world reflected in living color – but upside down!

This, of course, is because of the behavior of light rays – when they’re pushed through this kind of tiny hole onto a flat surface, they cross and reform as an inverted image.

People have been experimenting with the pinhole camera, or camera obscura, since at least the 5th century B.C., and probably before (there’s a theory that the distorted animals seen in cave paintings were inspired by pinhole reflections in caves).

The Chinese philosopher Mo-Ti first recorded the phenomenon in 5 B.C., calling the darkened room the “locked treasure room.” And Leonardo da Vinci studied and wrote about it – in backwards writing, of course! It was used as an artist’s aid in the 17th and 18th centuries, too.

Eventually, the dark room became a box… the flat surface became photographic paper… and the camera obscura developed into the camera we know today…

But what’s perhaps most amazing is that the pinhole camera almost perfectly mimics the function of the human eye.

Light comes in through the iris – the pupil contracts to create a tiny pinhole…

Passes through the lens, and reflects perfectly on the flat wall, or retina. (Our marvelous brain then corrects the upside-down image.)

If you can understand a pinhole camera, you can understand the beautifully complex human eyeball.

And that brings me to our topic today…

Rather than sift through endless numbers and financial statements to understand the health of a company, there’s one tiny, simple number I look at that lets me know if it’s a good idea to make a trade.

If you can understand a pinhole, you can understand this – and it will likely change the way you look at stock picking forever.

Skip All the Confusing Numbers and Go Straight to Operating Cash Flow

There are many parts of fundamental analysis – or the understanding the value of a company and hence today’s stock price. There are qualitative ideas like the caliber of the management team.

There are forward-looking components like what new products or services a company might introduce in the near or distant future. And then there are the purely quantitative “hard numbers” that we find in a company’s financial statement.

Of the “big three” parts of a financial statement – income statement, balance sheet, and cash flow – cash flow is really the most important and tells you the most about the financial health of a company.

Operating cash flow (or cash flow from operations) is by far my favorite fundamental indicator. You can “bend” a lot of numbers in a financial report, but it’s tough to mess with cash flow! Operating cash flow lets us see the stream of revenues and expenses before things like investment, interest, and capital expenditures are calculated.

Looking at the trends for operating cash flow gives us a great tool for looking at the quality of a business over time – and finding the best stocks.

When you look up a company’s cash flow statement (more on that below), you’ll see three different areas of cash flow: operating, investing, and financing. Investing includes the money the company invests in itself, that is, spends to make itself better – often, on things like facilities and staffing – as well as any investments it makes in other companies.

Financing includes the things the company does to raise more money for itself – usually by issuing debt (bonds) or equity (stock). These statements can be a little complicated to parse and often don’t tell you as straightforward a story as you’d like. (For instance, it’s sometimes expected and fine to see a negative number at the bottom of the investing section – since spending that money helps the company long term.)

However, operating cash flow is blessedly simple – and it also tells you the most straightforward story about how well the company is doing…

Operating cash flow is the actual amount of cash a company receives from customers less the amount it spends in expenses over the course of the year… and it is very different from “profit,” which can be selectively “adjusted” by tweaking other parts of the financial statement.

Companies are often prone to misuse accrual-based accounting (the type of accounting that allows ledger entries to be made when actions are taken versus when cash changes hands) to make themselves look more successful than they are – logging profits far in advance of any money they’ve actually received!

For instance, one of the strategies Enron used to cover its tracks was to book 20 years of “advance” profits! That kind of account bending is now much harder to pull off. And even during that scandal, savvy analysts were pointing to Enron’s cash flow as a “red flag” for the company’s financial health. When there’s a big discrepancy between “profits” and operational cash flow, that’s a big tip-off that something isn’t right.

In order to get a quick, accurate snapshot of the financial health of a company, you can skip all the fancy math and go straight to operational cash flow.

Cash is a tremendously useful and simple benchmark, as our friend Warren Buffett tells us: “Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.”

So here’s a quick look at how to find operational cash flow for the company you’re interested in – and how to tell what it means.

Your Quick Cash Flow Primer

First of all, head on over to Yahoo! Finance, plug in your company, and click “Financials.”

Voila – up top you’ll see the Big Three – income statement, balance sheet, and cash flow.

They automatically send you to the income statement first, so pick cash flow.

Once you’re on the cash flow page, you’ll see the final number (the amount of cash the company had at the end of the year) listed at the bottom as “total cash flow from operating activities.” You can see the last three years over to the right.

What you want to see is the cash flow amount going up, preferably over multiple years.

Check out BABA’s cash flow from 2015 through 2018 here. Nice!

This is a great exercise to do for any company you’re interested in (it’s definitely one of the first things I look at).

— D.R. Barton,Jr.

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Source: Money Morning