In almost every stock analysis, the reported (or projected) earnings per share is referenced as a proxy for how well the company is performing or is expected to perform.  However, after reading through a number of company’s annual reports and various investing blogs, I’ve come to think earnings aren’t all they’re cracked up to be.

The Earnings Illusion
When it comes right down to it, companies required cold hard cash to function.  Whether it be paying their employees, paying interest on debts, or replacing old equipment, every transaction worth noting is really a cash transaction.  That’s why I’ve become much more interested free cash flows when analyzing a business.  In the income statement, earnings are calculated by taking sales, subtracting the cost of sales and other expenses, accounting for some depreciation and amortization, one time costs, interest, taxes, and voila, net income for the year.  The unfortunate thing is, some of these ‘expenses’, especially depreciation and amortization, may have no relationship to the actual replacement cost (or useful life) of the asset that they’re accumulating on.

An easy way to illustrate this concept is by looking at the financial statements of a railway, say Canadian Pacific.  If you pull up the current income statement and statement of cash flows, you’ll see that the depreciation expense ($489.6) is significantly less than the expenditures for property, plant and equipment ($726.1).  This is because railways are a capital intensive industry that relies on long-lived assets.  When a railway replaces a section of track, they account for this expense by ‘depreciating’ (spreading out) the expense on the income statement (to calculate earnings) over the assumed useful life of that segment (say 25 years).  Now, when it comes time to replace this section of track in 25 years, inflation (assumed at 3% per year) will cause the same piece of track to cost more than double what it had the last time it was replaced.  What all this ends up meaning is that the actual cash spent on replacing these types of long-lived assets will almost always be greater than the depreciation allowance that can be ‘claimed’ due to the effects of inflation.  Therefore, if you’re interested in investing in railways (or similar types of capital intensive companies such as utilities), make sure to take a good hard look at their free cash flow numbers (operating cash flow minus purchases of property, plant, and equipment or maintenance capital) in relation to reported earnings to get a more accurate picture of the stocks ‘true’ profitability.

The Bottom Line
One of the reasons that earnings are all of the rage, is that up until relatively recently (late 80’s), there was no way to get an accurate picture of the cash generated by a company as the statement of cash flows was not included in the reporting requirements.  I’m almost certain though that had cash flow information been easily available back in Graham’s day that he would have used it instead of earnings when evaluating potential stocks.  Warren Buffett certainly does, as free cash flow is very similar to his concept of Owner’s Earnings.

By evaluating potential investments based on their free cash flow instead of earnings, investors have the potential to discover some mispriced bargains.  As free cash flow is rarely tracked or reported, most investors don’t pay attention to it.  And if people don’t pay attention to something, it isn’t likely to factor into the stock price.  All it takes then is a little research and patience when investing in these scenarios to eventually be rewarded with stock buybacks, dividends, internal growth, and accretive acquisitions as free cash flow is (hopefully) used to enhance shareholder returns into the future.

At the end of the day, it does still pay to remember that cash really is king.

Until next time,
Nathan @ EngineeringIncome.com