The Importance of Cash Flow (vs. Earnings)

July 22, 2009

Dear Investor:

The disparity between cash flow and earnings is leading people to severely underestimate the current value of stocks.

When I teach corporate finance to my NYU students, I ask them to understand it this way: cash flow is real money, earnings are not. Imagine you run a pizza parlor. The money you take in (less what you pay out in expenses) is cash flow-the actual net cash taken in at the register. Earnings, on the other hand, are what accounting rules say you made-after they adjust your real cash for various sleights of hand, such as accruals, depreciation, amortization, and impairments to book value.

No real owner, including a shareholder, should care too much about earnings, which are accounting fictions. They should-and do-care about real money.

Cash flow has always differed from earnings in meaningful ways, sometimes being dramatically smaller, other times larger. But recent changes to accounting regulations have caused drastic variations that understate earnings more than ever before.

Consider the simple formula for earnings (aka “net income”):

Earnings = Revenues – Expenses

Unfortunately, under the “expenses” umbrella are more non-cash items than ever. The formula for operating cash flow adds backĀ  non-cash charges to compute real money:

Operating Cash Flow = Earnings + [Depreciation + Amortization + Goodwill Impairment Charges + Other Non-cash charges]

Due to the relatively new treatment of goodwill impairment (whereby charges to goodwill must be taken immediately instead of being amortized over time) and to recent changes in mark-to-market accounting (whereby many fully performing loans still have to be marked down), nearly all sectors of the economy are showing exaggerated non-cash write-offs that are artificially depressing earnings.

The S&P 500, for example, is currently trading at 940, or at 15.2 times the trailing twelve month aggregate earnings figure of $62 per share. But the S&P 500 is trading at only 5.7 times operating cash flow over the same period. This discrepancy is historically vast.

If you invert the price-to-cash flow ratio of 5.7, you get an operating cash flow yield of nearly 18%!! This is a remarkable yield compared to 10-yr Treasury Bonds earning nearly 4%. Even if you subtract large capital expenditures from operating cash flow, you still get a “free cash flow” yield of over 10%. For comparison, the ten year average for operating cash flow yield is around 7% and, for free cash flow, around 4%.

Most value investors, including Buffett, rely on cash flow to avoid the accounting fictions of earnings. A cash flow analysis requires a little more work and extra know-how, but this really shouldn’t keep investors from discerning the true value of stocks.

As a result, we’re keeping equity allocations high, even in the wake of the 40% run-up since March. Despite the mongering of fear and the predictions of Armageddon by pundits and economists, it’s clear now that we are experiencing a recession, not the Great Depression.

The recovery will be uneven and slow; one step back will hinder every two steps forward. But the overall trend will be upwards from here. As a result, stocks-which were priced for perdition in March-show compelling value.