A Simple Tool That Effectively Analyzes Stocks

Last week, The Wall Street Journal ran an article with the headline “Earnings: Not as Advertised.” It looked at the difference between generally accepted accounting principles (GAAP) earnings and non-GAAP earnings – and how the market’s valuation of a stock changes depending on which you use.

GAAP earnings are typically the more conservative measure. Non-GAAP will exclude certain one-time charges. (Which is why it can make sense to use non-GAAP to compare a company’s results from one year to the next.)

[ad#Google Adsense 336×280-IA]The P/E ratio of the S&P 500 based on GAAP earnings is 21…

But it is below 17 using non-GAAP reporting.

Understandably, this can be confusing to investors. So today I’m going to share a less complicated but equally important metric that I use daily: cash flow.

The thing I like about cash flow is there aren’t as many ways to play with the numbers as there are with earnings.

For example, when reporting earnings, a company includes stock-based compensation as an expense. So if a company made $10 million in profits and issued $1 million in stock to employees, that brings the net income down to $9 million. Even though the company did not actually shell out $1 million. It simply gave out shares.

When calculating cash flow, however, you would add that $1 million noncash expense back to net income to get $10 million. Because cash flow measures how much cash a company generated. Period.

Another example is depreciation. When a company buys a piece of equipment, GAAP says it is allowed to take a percentage of the cost as an expense each year for several years. This lowers earnings (and, as a result, the tax bite).

If a company paid $1 million for a piece of equipment in 2015, in 2016 it might be able to take $200,000 in depreciation expense, lowering earnings and taxes. But the company did not spend that $200,000 in 2016. So when we calculate cash flow, we add $200,000 back to net income for a more accurate representation of the company’s business.

Additionally, sales can be pushed backward or forward in a quarter to land on the revenue or earnings figure that management wants. Fortunately for us, those numbers will show up in accounts receivable, which is also used in the calculation of cash flow but not earnings. So we’ll know for sure how the business operated in the quarter – no matter what management tells us.

Cash flow can also be an indicator that something is up with a company’s accounting. If earnings are continually strong but cash flow is not, that may give you a signal that the company is cooking the books.

WorldCom, the now defunct telecom, is a perfect example.

The company overstated earnings by counting normal operating expenses as capital investments, which are not used in the calculation of profits. By removing those expenses from the income statement, earnings appeared higher than they really were.

However, when you determine free cash flow, capital investments are included. So even though WorldCom’s earnings were fraudulently inflated, cash flow told the truth.

Earnings are important when analyzing stocks. But you should also look at cash flow.

As I’ve shown you, the nice thing about this metric is there is generally only one way to calculate it. There’s no GAAP versus non-GAAP. It’s just cash flow. It eliminates the accounting tricks, and measures how much cash comes into the business or flows out of it.

It’s neat, clean and should absolutely be in your toolbox as an investor.

Good investing,

Marc

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Source: Investment U