Does the opinion on profit and does it in cash?

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In today’s Money Morning…cash versus profit: the academic debate…profit metrics versus cash flow…the importance of systematic analysis…and more…

Money is a fact, profit is an opinion.

Alfred Rappaport

Our ultimate financial metric, and the one we most want to track over the long term, is free cash flow per share.

Jeff Bezos

It is much easier for investors to use historical P/E ratios or for managers to use historical business valuation criteria than for either group to rethink their premises daily.

warren buffet

The reporting season is well underway.

And as one company after another lines up to publish their accounts, investors are faced with the perennial question: profit or cash?

Specifically, when analyzing a company’s performance, which is more important as a metric – a company’s reported earnings or its cash flow?

As companies continue to report their annual results, attention is turning to the bottom line of the income statement.

Did this business make a profit? Has his income increased? Is the profit margin healthy?

Less attention is paid to species. How much cash does the company generate from its operations? Is free cash flow positive?

Cash versus profit: the academic debate

Analysts and financial scholars have debated the usefulness of cash versus earnings for years.

In 1998, Alfred Rappaport, in his book Create shareholder valueproclaimed that “Money is a fact, profit is an opinion‘.

Rappaport argued that cash is more difficult to massage than accounting profit, which relies on accounting policies and assumptions that are more subject to adjustment.

This can lead to significant discrepancies between reported earnings and reported cash flows.

In a research note, respected financial analyst Michael Mauboussin wrote that the difference between earnings and cash flow is “significant”.

Studying data from the Dow Jones Industrial Average, Mauboussin and his colleagues found:

The range of the cash flow to earnings ratio within the DJIA fluctuated from minus 0.08 to above 2.6.

This means that earnings and P/E comparisons can be very misleading because they don’t provide insight into a company’s underlying economics..

Earnings versus cash flow metrics

A key argument for prioritizing cash flow analysis over earnings is the fundamental valuation principle that a company is worth the present value of its forecasts. future free cash flow.

But even though market participants may remember the valuation theory that values ​​discounted future cash flows rather than earnings, it is earnings that dominate the discussion.

Earnings per share and price-to-earnings ratio are ubiquitous, widely shared, and frequently communicated metrics.

But profit measures are imperfect, especially if we use them as a shorthand for assessing value.

As Stephen Penman wrote in value accounting, when we ‘calculate the value to dispute the price, beware of using the price in the calculation.’

Along the same lines, earnings measures could also mislead us into thinking that a company is healthy and improving.

Earnings growth is not always a good thing.

As Mauboussin explained in an article for the harvard business review:

EPS growth is good for a company that earns high returns on invested capital, neutral for a company with returns equal to the cost of capital, and bad for companies with returns below the cost of capital. Despite this, many companies slavishly pursue EPS growth, even at the expense of value creation.

Theory and empirical research tell us that the causal relationship between EPS growth and value creation is tenuous at best. Similar research reveals that sales growth also has a weak connection to shareholder value.

An in-depth example of Mauboussin’s perspective can be found in a letter to shareholders authored by none other than Jeff Bezos.

During his time running Amazon, Bezos advocated free cash flow per share as the defining indicator of Amazon’s financial performance.

Echoing Mauboussin, Bezos noted:

Although some may find this counter-intuitive, a company can actually hurt shareholder value in certain circumstances by increasing profits. This occurs when the capital investments needed for growth exceed the present value of the cash flows from those investments.

You can read Bezos example in depth here.

Elsewhere, in a research note for investment bank Credit Suisse, Mauboussin confirmed Amazon’s valuation methodology, saying investors should think more about future cash flows:

Investors should focus on the key drivers of value and cash flows generated by a company to identify investment opportunities.

Harder to do than playing with earnings multiples, but closer to the heart of the matter.

Investment parameters should not confer value on a business. Instead, investment metrics should reflect a company’s underlying and future performance.

The measures are derived and not determinative.

After all, as Penman further explains in his book:

The value, and even the risk, lies in the companies that make up the market’s portfolio, so take a look at those companies. You don’t buy a stock, you buy a company and when buying a business, know the business.

That said, while many people who study the financial industry prefer to focus on cash flow to determine value, cash flow is now immune to manipulation.

While cash flow advocates argue that income can too often be smoothed, adjusted and managed – suggesting that profit is opinion, money is fact – cash flow can also fall victim to a financial massage.

Accounting professor Baruch Lev, in his 2016 book The end of accountinghad bad news:

Although the ending cash balance and the change in cash from period to period are not easily subject to manipulation, the components of total cash flow, operating, investing and financing amounts are more likely to be managed…

Free cash flow is generally defined as operating cash flow minus capital expenditures and, for companies that pay them, preferred dividends. So while analysts, investors, and creditors might be led to believe that operating cash flow and free cash flow are somehow above the creative accounting fray, this belief is unfounded. Operating cash flow and free cash flow are subject to manipulations which, unfortunately, often occur.

It is likely that the corrosion of earnings and cash flow reliability has led to a decline in the correlation between financial statement information and stock performance.

In Baruch Lev’s book The State of Modern Accounting, Lev reports that the relevance of corporate financial information to investors has fallen from 90% to around 50% over the past 60 years:

The importance of systematic analysis

Imagine a visit to the doctor after having extensive blood work and other tests.

You wait nervously to hear the doctor’s interpretation of the data.

Instead, the doctor simply grumbles, “Your cholesterol is 195. Pretty good. Next patient.

Perplexed and irritated, you storm off.

Obviously, you wanted the doctor’s assessment to involve more than a single number. How can a number explain my general well-being?

But that’s, in a nutshell, what many investors do with stocks, says accounting professor Lev.

We often focus on a single indicator, thinking it can tell us everything we need to know about a stock’s current and future performance.

But just as a terse visit to the doctor would leave us hungry, a single indicator should leave us wanting more.

Ultimately, there is no magic number or metric.

And while cash flow is key to determining the long-term value of a business, calculating future cash flow involves a lot of thinking, analysis, and crunching numbers — no magic numbers here.

As Lev concluded:

Analyzing a complex, often global, business organization subject to competition and rapidly changing technologies requires a comprehensive system of well-integrated indicators and contextual information. It is a mosaic; no shortcuts.

A good investment involves no shortcuts.

Cheers,

Kiryll Prakapenka,
For silver morning

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