Our ‘Earnings’ Obsession
They are called “Earnings Calls”
Defined by Investopedia as “A conference call between the management of a public company, analysts, investors and the media to discuss the financial results during a given reporting period such as a quarter or a fiscal year. An earnings call is usually preceded by an earnings report, which contains summary information on financial performance for the period.”
The financial media has it front and centre as the metric to watch and report.
No wonder then that we seek out “Earnings per Share” more than other investment metrics.
So what’s wrong with Earnings and EPS?
Profit (Earnings) is an opinion
Earnings per Share is the portion of the company’s profit that is allocated to each outstanding share of common stock, i.e. Earnings per Share = Net Income / Average Outstanding Shares. This same EPS is the E in that other popular valuation metric; P / E (Price / Earnings) Ratio
Focusing on Earnings per Share to gauge a stock’s investment-worthiness is the same as assuming an eight-figure-salaried-BMW-driving-expensive-penthouse-owning-Rolex-flashing-professional is a truly wealthy person.
The problem becomes apparent the moment you unbundle ‘Net Income’:
Gross Sales – Operating Expenses – Interest – Depreciation – Tax = Net Income
- Gross Sales consider material / services sold and invoiced, not necessarily money collected
- Company A: Collects payment upfront for all products sold in the month
- Company B: Has long term contracts with tech startups (some of which have lifetimes in months) , collects payment at the end of each quarter
- Operating expenses are just those. Net Income doesn’t consider the impact of new / replacement plant / machinery being bought. What gets classified as an “operating” expenses itself is open to some interpretation
- A: Modernised it’s plant last year and will not incur capital expenses for the next seven years
- B: Has an antiquated production line for which it has to keep buying replacement machines to keep production at current levels
- Depreciation is a non-cash expense meant to notionally capture the impact of wear and tear of the plant and machinery by smoothing out large one-time expenses over longer time frames. How aggressive a company is in “writing down” it’s capital investments has a bearing on the Net Income it shows
- A & B: Non-cash expense that notionally captures the effect of wear and tear and smooths a one-time expense over time
Cash is a fact
Cash from Operations – Investment in Operating Capital = Free Cash Flow
It’s that simple. Cash generated by the business net of outflows for long and short term investments to maintain / grow the business. So that’s cash leftover after having ploughed back whatever is needed by the business to sustain itself, and therefore is available to be distributed to shareholders.
Negative or low FCF is not necessarily a bad thing, it just means the company is still investing in (hopefully) building it’s capabilities. Over time, you’d like to see this need reduce as more of the Earnings flow through to free cash available to shareholders. And that’s the ultimate test of a promising investment.
in the end, its simple:
the company that generates most free cash flow w/ fewest assets wins.
— Tyler Hogge 🎯 (@thogge) July 14, 2017
Free Cash Flow is not reported as obviously as Earnings are but there are resources available like screener.in and morningstar that do show FCF / share along with EPS.
Here’s a more comprehensive checklist of characteristics to look for in a stock to invest. And if you’re trying to find your very first stock to buy, here’s exactly that: your guide to buying your first stock. And something not many investors feel comfortable talking about, where they went wrong. So here are my biggest investing mistakes.
Finding value in earnings transcripts – link
What’s more important, cash flow or profits? – link
Most read articles on TCI – link