The financial metric that matters more than profits

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.

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.

 

Further Reading:

Finding value in earnings transcripts – link

What’s more important, cash flow or profits? – link

Most read articles on TCI – link

2 thoughts on “The financial metric that matters more than profits

  • July 17, 2017 at 5:42 am
    Permalink

    Good thoughts. Indeed “Cash flow” is King for those running the business as well as for those investing in the business.
    Buffet put it greatly in his 1992 shareholder letter:

    “In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.”

    Regards
    Ravichand

  • July 17, 2017 at 7:40 am
    Permalink

    Thanks for sharing Ravi. John Burr William’s quote is simple and yet makes so much sense.

What do you think?