In each of the previous parts of this series, I’ve been showing you how to break down and understand the annual report for a company. Last but not least, here’s how to do cash flow statement analysis.
Cash flow statement analysis is important for several of the following reasons. For one, it can signal potential value that the income statement has not uncovered yet. On the flip side, it can also warn of a company whose earnings look good on the surface but actually these earnings are in jeopardy.
The cash flow statement is a much better representation for how much cash they actually have in the “bank”. Think of it like the way you do your personal finances. The cash flow statement would be like your bank account statement, while the income statement is more like your monthly budget. The balance sheet, as I’ve shared before, is like your net worth.
Remember that the name of the game is earnings… because that turns into cash, which gets paid to the shareholder. So while earnings seems to be the sole focus on Wall Street, there are still some steps to take before those earnings become usable cash.
In fact, the cash flow statement is often an early indicator for future earnings. The reason for this is that higher cash flow numbers lead to more earnings, and thus share price appreciation, because more available cash allows management to throw more money into growing the business.
The share price can also appreciate from higher cash flow numbers being used to pay more dividends, as shareholders love special dividends and dividend increases and will tend to buy more when management is showing this. Earnings and the income statement alone won’t be able to tell you this, which is why the cash flow statement is so important.
Cash Flow Statement Analaysis
There’s 3 major ways to do cash flow statement analysis. I only use one of these ways, but it’s important for me to show you all 3. Examine them and use the one that makes most sense for you.
You can use either:
- Price to Cash ratio
- Discounted Cash Flow Model (DCF)
- Free Cash Flow ratio (FCF)
No matter which one you choose, you must be consistent. It could cripple your strategy if you are using DCF one year and then FCF the next. It’s not so important which method you choose, but more that you stick to one method. Any investing strategy will have overperformance and underperformance, but a strategy that always changes will always underperform.
Monitor the growth and change of cash flow from year to year. You always want growing cash flow and earnings, for obvious reasons. Obviously you always want the lowest valuations possible, but the world isn’t a perfect place and there’s always going to be give and take. I’d rather have decent valuations with numbers going in the right direction, than ultra low valuations with sporadic growth and decline.
Price to Cash ratio
This is the simplest method of the 3, and the one that I subscribe to. It works exactly the same as P/E and P/B, like I discussed in previous posts. Here’s how to calculate it:
Price to Cash = [Price] / [Cash]
Price to Cash = (Market Capitalization) / (Net Cash at End of Year)
Generally you want a P/C below 10. It’s ok if it’s slightly over, and I’ll even loosen the restrictions of my screens if the market is especially overvalued.
The important part of this ratio is that you are checking for it. The difference between a P/C of 10 and a P/C of 12 will probably mean nothing, but the difference between a P/C of 100 and a P/C of 10 is too big to ignore. It’s a safe bet that the P/C of 100 stock is having cash flow problems.
A method like this will not be the cornerstone of an investing strategy. For the way that I’m using it, it’s just a check and safety precaution. I’m not optimizing my picks by trying to find the lowest P/C stocks. For me personally, I find value and really hunt for it in other places (See Income Statement and Balance Sheet).
You’ll see that the other 2 methods are more complex and more of the center of its investing strategy. That’s fine and really it depends on how the methods serve you. The simplicity of P/C works for me because of what I need from it, which is to prevent cash flow problems.
Discounted Cash Flow Model (DCF)
(n is the number of years)
You’ll see this model often used in appraising investment real estate. It’s commonly used as the primary way to evaluate a business in corporate finance and even for patent valuation.
A chief problem with this method is that it makes several assumptions, including a constant interest rate. As we know from the long history of the market, interest rates are always in a state of change.
Also, the formula attempts to predict and set a value for future cash flow. This can inherently create problems as well. Finally, the formula assumes straight line growth over many years, which is obviously ideal but rarely happens in the real world. The longer the number of years being used to calculate DCF, the greater the number of inaccuracies can be made.
Free Cash Flow Model (FCF)
FCF= EBIT (1 – Tax Rate) + (Depreciation & Amortization) – (Change in Net Working Capital) – (Capital Expenditures)
FCF= Operating Cash Flow – Capital Expenditures
(where EBIT is Earnings before interest and tax)
To compare a company with another, use the FCF ratio.
FCF ratio (FCF Yield) = FCF / Market Capitalization
This ratio is actually used as part of the DCF calculation made above. While there’s nothing wrong with the ratio itself, it depends on how you’re trying to use it. The problems with DCF outlined above don’t apply to FCF, yet like any measure it has its flaws.
While FCF can be useful to guard against earnings manipulations, the numbers in FCF can be easily manipulated themselves. Maintenance capex (capital expenditures) is not required to be reported by GAAP auditing standards. So, management can choose whether to disclose this or not, which could greatly affect FCF numbers.
The bottom line is that management can really manipulate accounting quite easily. This is why GAAP is always changing, and will always continue to change.
You can’t predict where the next accounting manipulation will come from. However, deceit in accounting statements can’t be hidden forever, and they always show up somewhere else. This is why I put so much emphasis on analyzing all 3 financial statements: income statement, balance sheet, cash flow statement. By being diligent with all 3 analyzes, you can limit your exposure to stock market disasters almost completely.
**Simple Cash Flow Statement Analysis for Stocks**
**All Rights Reserved. Investing for Beginners 2014**
START FROM THE BEGINNING:
1. How to Read Annual Reports for Beginners
CONTINUE READING THE GUIDE:
2. Simple Balance Sheet Analysis
3. Line-by-Line Balance Sheet Breakdown
4. Simple Income Statement Analysis
5. Line-by-Line Income Statement Breakdown
6. Simple Cash Flow Statement Analysis
7. Line-by-Line Cash Flow Statement Breakdown