With 10-K season upon us, I’m continuing on the theme of accounting this week. My last post looked at 10 things to look for in the 10-K. As one of my readers pointed out, I neglected to include anything about cash flow in that list. So this week my focus will be entirely on this important statement.
Understanding a full set of account is something that requires both time and patience – two assets that many professional investors seem to lack. In my professional career I’ve come across far too many people who have a strong aversion to getting their hands dirty with the accounts. Sometimes it’s a sense that such work is somehow “below them”, or that such work should be done by a junior. In other cases it’s lack of confidence with accounting or just old-fashioned laziness. What I do know is that the world’s greatest investors revel in digging into the accounts – and they’re happy to do it themselves.
The concept of the cash flow statement seems to cause a huge amount of confusion. There is often a naive sense that cash is a “better metric” than income because it can’t be manipulated. The cliché of “Cash is King” is invoked in these situations as a substitute for detailed work. Here is how many of these discussions go:
Manager: Hell, I’m not buying this stock. It’s on a P/E of 28 times – are you kidding me? What are you thinking?
Analyst: Don’t be misled by the PE Ratio here. It’s much better to look at cash flow – you can’t manipulate cash flow can you?
[Meaningful pause while minions nod along wisely….]
Analyst: Look….EV/EBITDA is only 7x. That’s in line with peers, and for a growth company like this….well, it’s a bargain.
Manager: Yeah..I see. Perhaps cash is the better metric to look at here. Still, why is the P/E so damn high? I’d like to understand that.
Analyst: The depreciation charge is artificially high because of recent investments in the new factory. Those are unlikely to recur going forward. So looking at net income here is very backward looking. Understand?
Manager: um…yeah I got it.
There are several things wrong with this conversation. First off, in what world is EBITDA a proxy for cash? You’ve just added back depreciation and conveniently forgot to deduct any charge at all to reflect the capital spend. Isn’t this manipulation of the worst kind? Wall Street’s obsession with EBITDA was raised in Buffett’s 1987 letter to shareholders:
“Most sales brochures of investment bankers…feature deceptive presentations…These imply that the business being offered is the commercial counterpart of the Pyramids— forever state-of-the-art, never needing to be replaced, improved or refurbished”
In any case, the idea that cash flow always trumps net income is a naïve one. If we were to rely on cash measures alone, we may as well go back to the cash accounting methods of 15th century Italy. The entire reason we introduced accrual accounting is because cash accounting doesn’t give a true picture of the state of affairs of the company. Cash may be received upfront for work done over an extended period, expenses may be incurred before a bill is paid, and investment capex will be lumpy from year to year.
Of course, GAAP accounting is not perfect easier. The fact is that no single set of accounts will provide us with the truth. It’s simply not an either or choice here – we need to dig deeper.
“Questioning GAAP figures may seem impious to some. After all, what are we paying the accountants for if it is not to deliver us the “truth” about our business. But the accountants’ job is to record, not to evaluate. The evaluation job falls to investors and managers” Warren Buffett
The cash flow statement then should be used as one of our tools in evaluating the business. We should never accept it as the “truth”, but as a starting point for our investigation. Now we’ve covered that, let me share some of the things I look for in the cash flow:
- Cash conversion rate.
How do earnings compare to cash generation over 10 years? Calculate cash flow from operations, deduct cash for investing activities, then compare that figure to net income. If there’s a low rate of cash conversion over time (under 75%) then something may be very wrong. Here are some of the most common explanations:
- Aggressive accounting or other accounting shenanigans
- Capital-intensive growth. This is not always a problem, provided that the additional capital spent has generated growth. If the business has a low ROIC, then this strategy may have destroyed value over time..
- Highly acquisitive. There are some companies that generate value by purchasing and integrating smaller companies. As a rule however, a highly acquisitive strategy will destroy value.
- Get a sense for how cash is used
Look at the split of cash flow between operating, investing and financial (all cash flow statement are arranged in this way). This will give you a good sense for how cash moves around the company. Is cash from operations being spent on investing activities? If free cash flow is negative, how is it being funded? If it’s positive how is it being used – retained, as dividends or for share buybacks? How much has been returned to shareholders over the last 5 years? Is the trend accelerating? These questions help you to understand the cash position of the company today and construct your estimates for the future.
- Capital Expenditures
Understanding the nature of capital expenditures is essential when it comes to making future estimates. You will want to go back at least five years to look at the pattern of spending, as well as the average spend. You also need to get a sense for the split between maintenance and growth capex. This is one of the toughest jobs for an analyst, and it’s an area where the science and art of valuation meet. The information provided in the statements is unlikely to be sufficient, so a fair degree of judgment will be required.
The cash flow statement is hugely valuable to investors who know how to use it. As with everything in finance, the temptation is always to reduce it to one number. If you can avoid this temptation I have no doubt the extra work will pay off!