“If you call a dog’s tail a leg, how many legs does it have?... Four, because calling a tail a leg doesn’t make it one.”
I’ll warn you the reader that this blog post is going to be heavy on the discussion of accounting, so while it may not be the most exciting blog post I’ve ever written, it is probably one of the more important ones to understand.
One of the things that we try and do when assessing a company to invest in is that we look at the company as a business, and not as a piece of paper. As such we don’t care as much about what the company’s earnings are on paper, but rather we care more about how much cash that company can put in our pockets as the shareholders. Most business media and even analysts at big banks or mutual fund companies tend to focus on earnings. But earnings don’t necessarily translate to money in shareholder’s pockets. And they don’t always capture all of the costs of a business. What’s more, earnings are more likely to be manipulated through accounting trickery and are therefore less reliable.
But if we’re not going to use earnings to judge a company’s performance, then what will we use? Well the metric that I like to use is a metric called the free-cashflow of the business. In my opinion free-cashflow is a much better representation of how much cash the business can generate for its owners.
The obvious question is, what is free cashflow and how does it differ from earnings? Unfortunately this is where it gets a little bit heavy in accounting terminology, but bear with me as I will try and make it easy to understand.
A company’s earnings are essentially the profits of the business. You calculate them by taking all of the revenue of the business and deducting all of the costs in a given time period. These are shown by the company’s accountants in the income statement for the company.
Earnings are supposed to represent the true profits of the business but they don’t really correspond to the cash generated by the business because you can have non-cash earnings or non-cash losses. This essentially means that you have earnings that haven’t actually generated any cash for the business, or you have losses that didn’t require the business to pay out any cash. I won’t get into all of the reasons why this happens but for our purposes it’s enough to know that it does happen in many businesses.
What is also not included in earnings is cash that is required to re-invest in capital in the business to keep it running. A good example would be if your company was growing and you needed to expand rapidly to maintain your competitive position. This means almost all of your cash generated by the business would have to be re-invested in the business and no cash would be available to distribute to shareholders by dividend. I won’t get into the complexities of what types of payments get expensed and show up as a deduction to earnings and what types of items get included in capital investments and would not show up in earnings either immediately or at all. Sufficive to say, cash re-invested may or may not affect earnings, and the fact it’s not all included in the earnings number means that the number can be distorted and not truly reflect the benefit generated for shareholders.
To get around this problem we use free-cashflow as I mentioned. Free-cashflow is determined by calculating the amount of cash generated by the operations of the business (excluding things like borrowing or repayment of loans, or issuing or repurchasing shares) and then deducting the amount of cash which the company re-invests in the business for growth and ongoing maintenance of the business. Free-cashflow is shown on the cash flow statement for a business.
As usual with complicated ideas, I like to use examples to make sense of it. Say I own a lemonade stand with the following sales and costs in 2019:
Total sales of lemonade ($100)
Cost of lemons, sugar, and other ingredients ($30)
By deducting the costs of the lemons and other ingredients, which is my only cost as I’m a sole proprietor, you get the net earnings of the business which would be $70 ($100 - $30 = $70)
However during the course of the summer in 2019 I noticed that the juicer I am using is not working very well and will probably need to be replaced. In addition I’d like to buy a new stirring spoon and jug which will be more attractive to customers. The cost of all of this new equipment will be $50 which I will spend in 2019. Since these are capital items which I will use for more than one year and which I could resell, the $50 does not get deducted from my net earnings above. It will stay at $70. However in order to calculate my free cashflow, I would have to deduct the $50 as a cash outflow. Thus the amount of free cashflow is only $20 ($100 - $30 - $50 = $20).
As the owner of the business, I know that while my earnings were $70 on paper, I really only generated $20 which I could spend on my own personal use. As every business owner will know, it can be a big difference!
What makes cashflow even better as a valuation metric is it is harder to manipulate than earnings. Cashflow is simply counted and is hard to fabricate. Earnings can be distorted. Examples of this include Enron where the company would sign deals which would generate cash payments over 20 years, but Enron would book all of the profits from the 20 years into the first year. This greatly inflated the earnings of Enron and made it seem like it was a more profitable company then it actually was. Unfortunately for them, there was few ways they could hide the fact that even though their paper earnings were high, the cash generated from these contracts was a fraction of those earnings. As Abraham Lincoln’s quote above says, just because you call it earnings, doesn’t mean that it’s actually earnings.
As I mentioned, we like to think of ourselves as business owners. So when we go to buy lemonade stands (or any other business for that matter) we use the cashflow number and not the earnings number to try and determine how much cash the business can generate for us. Anybody looking to invest in a business would do well to understand the differences between cashflow and earnings and make sure they’re paying for cash that can be returned to them, and not earnings that only exist on paper.
- Craig White, BA, LL.B., CIM
Craig White is an Investment Advisor at the award winning firm Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.