Why cash is king when it comes to weighing up a firm’s position
• Growing profits and negative cash flow at the operational level should be a red flag
Ask an Englishman how wealthy someone is and you’re likely to hear a response like, “he’s worth 20,000 per year”, says William Bernstein.
This sort of answer usually confuses the less sophisticated, he says, but it is an estimable response because it says something profound about wealth: it does not consist of inert assets but, instead, a stream of income.
“If you own an orchard, its value is defined not by trees and land, but by the income it produces. The worth of a house is not what it will fetch, but the value of its future cash flow.”
Or, as Gamco Investors founder Mario Gabelli, puts it: “When the informed industrialist is evaluating a business for purchase, he is not going to put a lot of weight on stated book value. What he wants to know is: how much cash is this business throwing off today and how much will he have to invest to sustain or grow this stream of cash in the future.”
We forget the importance of cash. We forget that the only unforgivable sin in business is to run out of cash. Analysis of yearon-year changes in a company’s net cash position is neglected at one’s peril. Companies have huge leeway to make profits what they want them to be.
Any sensible financial director will maintain a stockpile of provisions available for release as and when required. This means earnings growth can be little more than the difference between two numbers that have been manipulated. Cash is more difficult to manipulate. Cash is a fact, profit is an opinion.
Be wary of companies with growing profits and negative cash flow at the operational level. Operating cash flow is similar to operating profit but without noncash items and accruals, which means it should exceed its net income and increase in proportion to net income. It should come as no surprise that observing the relationship between operating cash flow and net income can help pinpoint stocks with earnings issues. Operating cash flows smaller than net income signal possible issues at accounts receivables or inventories level, indicators of potential future earnings disappointments.
Comparing net income to operating cash flow is easier than computing accounts receivables and inventory percentages of sales. It is an efficient way to spot stocks that warrant further investigation. Rising net income accompanied by declining operating cash flow is a red flag. Common sense dictates that firms that habitually report more net income than operating cash flow are problematic.
That’s not to say negative operating cash flows always signal problems. Small, growing firms often absorb cash to finance burgeoning but necessary inventories and receivables. Nevertheless, academic studies have found that the stock of companies with positive operating cash flow outperform those with negative cash flow.
“We believe free cash flow, defined as earnings before interest, taxes and depreciation, or a slight variation, minus the capital expenditures necessary to grow the business, is the best barometer of a company’s value,” says Gabelli.
“Just as growth-stock investors will pay a higher price-toearnings ratio for higher earnings growth, [we] will pay a higher multiple of cash flow for faster cash-flow growth.”
Joel Greenblatt expresses the same idea: “Companies that are gushing cash, with high returns on capital, with nice niches and trading at low multiples to cash flow, if I buy a bucket of those, I’m going to do very well.”
While the relationship between operating cash flow and reported earnings may have something to say about the quality of the earnings, it’s not the only thing worth looking at in the cash-flow statement. Cash flows to/from investing activities affect noncurrent assets, including the purchase and sale of property, plant and equipment, and loans made to other entities — the cash inflows and outflows that speak to the longer-term prospects of a business. Cash flows to/from financing activities affect noncurrent liabilities and owners’ equity, including long-term debt, stock sales and repurchases, and dividend payments. They are the pulse of a company.
As Charlie Munger points out: “There are two kinds of businesses: the first earns 12%, and you can take it out at the end of the year. The second earns 12% but all the excess cash must be reinvested, there’s never any cash. It reminds me of the guy who looks at his equipment and says, ‘there’s all of my profit’. We hate that kind of business.”
There is a difference between a company with strong cash inflows and one that’s sitting on a big pile of cash. Too much cash sitting for too long on the balance sheet is a problem. You might imagine investors would reward companies with plenty of cash on the balance sheet. After all, cash offers protection against tough times and gives firms more options for future growth. Unfortunately, nothing in the market is quite that simple. For investors digging into company fundamentals, a big pile of cash can be a big turn-off. When it’s more or less a permanent feature of the balance sheet, they wonder why the money is not being put to good use. It suggests management has run out of ideas, in which case the cash might be better used elsewhere (returned to shareholders).
Besides, a cash-rich firm runs the risk of falling prey to careless spending and a reluctance to prune expenses. Unlike debt, large cash holdings also removes pressure to perform.
In theory, companies ought to keep just enough cash to cover operating costs, interest payments and capital expenditures; plus a little more for emergencies. Any extra cash over and above those levels should be redistributed to shareholders through dividends or share buy-backs. If the company discovers a new investment opportunity, it can always turn to the capital markets.
IF YOU OWN AN ORCHARD, ITS VALUE IS DEFINED NOT BY TREES AND LAND, BUT BY THE INCOME IT PRODUCES