We utilize free cash flow as our primary valuation component because it is one of the most difficult statistics for a corporation to manipulate. Alfred Rappaport summed it up nicely: “Profit is an opinion; cash is a fact.” So why is free cash flow a better (or more realistic) measure?
Why Free Cash Flow and Not Earnings?
Earnings, also known as net income, refer to the profit a company generates after subtracting all expenses from its revenue. It is calculated on the income statement by deducting expenses such as the cost of goods sold, operating expenses, interest, and taxes from gross revenue. Earnings can encompass both cash and non-cash items. For example, depreciation, which is an expense that reduces earnings, does not involve an actual cash outflow. Earnings are reported on the income statement. It’s essential to remember that earnings focus on profitability, whereas cash flow emphasizes liquidity—the ability to access cash. So why do we use free cash flow rather than earnings in calculating value in potential or actual portfolio holdings? Here are a few areas that can help illustrate the differences between earnings and cash flow:
Reporting Sources
Companies primarily use three financial statements to assess their overall performance and health: balance sheets, cash flow statements, and income statements. The cash flow statement records the company's accounts payable and accounts receivable. It helps reconcile the other two statements by illustrating the company's financial activity, like a checkbook; however, it doesn't always provide a complete view of all expenses and activities. The income statement reflects earnings, displaying the company's profits over a specific period. Income statements can provide a broader perspective on a business's performance and growth potential since they show profits after deducting expenses and costs.
How It’s Calculated
Another key difference between earnings and cash flow is how they are calculated. To determine earnings, accounting and financial professionals subtract a company's expenses from its revenue. Expenses include costs such as labor, supplies, rent, taxes, and interest. They can use these calculations to display earnings over a specific time frame, such as a quarter or a year. For cash flow, the calculation focuses solely on the company's actual inflows and outflows of cash. Any transactions occurring on a non-cash basis will not appear in the cash flow statement. The statements serve as an ongoing ledger that reflects the company's cash balance as of the end of a period.
The Two Can Create Two Distinct Views
When investors and shareholders conduct business valuations, they consider the company's price in relation to its earnings, cash flow, book value, or equity value. Therefore, both earnings and cash flow represent crucial figures to comprehend, as they provide unique insights to stakeholders. To achieve long-term, sustainable success, organizations must maintain both profits and positive cash flows. However, success in one area does not always equate to success in another. For instance, a company may be profitable yet still lack sufficient available cash to cover essential expenses, such as payroll or supplies, especially if it is waiting for customer payments or has not yet sold its inventory. In this case, profitability does not necessarily mean positive cash flow, and cash flow becomes a more critical figure for stakeholders.
Similarly, a company may temporarily enhance its cash flow by securing loans or selling assets. However, if its earnings are not adequate to generate profit, achieving profitability becomes increasingly crucial. Therefore, it is vital for companies to achieve profitability to ensure their ongoing operations.
Conclusions
Nintai is not entirely averse to using net income/earnings to evaluate a holding. Free cash flow is a more applicable measurement tool because cash is king. Our results in the 2007-2009 Credit Crisis have further strengthened FCF’s appeal in our research and valuation methods. We should note that this can require considerably more research time as we convert a company’s quarterly earnings report into a free cash flow quarterly report. But we think the effort is worthwhile.
FCF represents excess cash generated by a company that is available for distribution to investors, debt repayment, or reinvestment in the business. Because of that, our role as a shareholder and fiduciary for our investment partners means we are acutely interested in how cash will be deployed. If a company can achieve greater returns on invested capital by deploying funds toward strategic acquisitions or expanding existing operations, then we fully support such efforts. However, this is only if those returns exceed what Nintai, or its investment partner, can achieve independently. If the latter is accurate, we would like to see the capital deployed in the form of dividends. Additionally, if the company’s shares are trading at a significant discount to our estimated intrinsic value, then share buybacks might be the best use of cash. Free cash flow can assist us in any of these calculations where net income might not provide us the insight to recommend them.
For all these reasons, in addition to the previous analysis of FCF compared to earnings, we dedicate a significant amount of time to examining a holding’s FCF figures. We believe that, over the long term, a company’s share price will closely follow its free cash flow numbers.
I hope this provides you with a solid overview of why our valuation spreadsheets, along with many other documents, use FCF as a fundamental measure. Please don't hesitate to contact us with any questions or comments. My best wishes.
DISCLOSURE: Nintai Investments does not own shares in any company mentioned in this article.
- FCF accounts for changes in working capital, such as accounts receivable and payable, which can affect a company's cash position. Earnings may not fully reflect the effects of these changes on cash flow.
- Earnings encompass items such as depreciation and amortization, which are non-cash expenses that do not represent actual cash outflows. FCF, in contrast, emphasizes the actual cash a company generates, offering a more realistic view of its financial health.
- FCF considers capital spending on items such as property, plant, and equipment, which are vital for maintaining and expanding operations. Earnings may not fully capture the cash needed for these investments, while FCF does.
- FCF helps investors assess a company's ability to reinvest in its operations, pursue strategic initiatives, and sustain long-term growth. It also offers a clearer view of a company's financial health and its ability to endure economic downturns.
Why Free Cash Flow and Not Earnings?
Earnings, also known as net income, refer to the profit a company generates after subtracting all expenses from its revenue. It is calculated on the income statement by deducting expenses such as the cost of goods sold, operating expenses, interest, and taxes from gross revenue. Earnings can encompass both cash and non-cash items. For example, depreciation, which is an expense that reduces earnings, does not involve an actual cash outflow. Earnings are reported on the income statement. It’s essential to remember that earnings focus on profitability, whereas cash flow emphasizes liquidity—the ability to access cash. So why do we use free cash flow rather than earnings in calculating value in potential or actual portfolio holdings? Here are a few areas that can help illustrate the differences between earnings and cash flow:
Reporting Sources
Companies primarily use three financial statements to assess their overall performance and health: balance sheets, cash flow statements, and income statements. The cash flow statement records the company's accounts payable and accounts receivable. It helps reconcile the other two statements by illustrating the company's financial activity, like a checkbook; however, it doesn't always provide a complete view of all expenses and activities. The income statement reflects earnings, displaying the company's profits over a specific period. Income statements can provide a broader perspective on a business's performance and growth potential since they show profits after deducting expenses and costs.
How It’s Calculated
Another key difference between earnings and cash flow is how they are calculated. To determine earnings, accounting and financial professionals subtract a company's expenses from its revenue. Expenses include costs such as labor, supplies, rent, taxes, and interest. They can use these calculations to display earnings over a specific time frame, such as a quarter or a year. For cash flow, the calculation focuses solely on the company's actual inflows and outflows of cash. Any transactions occurring on a non-cash basis will not appear in the cash flow statement. The statements serve as an ongoing ledger that reflects the company's cash balance as of the end of a period.
The Two Can Create Two Distinct Views
When investors and shareholders conduct business valuations, they consider the company's price in relation to its earnings, cash flow, book value, or equity value. Therefore, both earnings and cash flow represent crucial figures to comprehend, as they provide unique insights to stakeholders. To achieve long-term, sustainable success, organizations must maintain both profits and positive cash flows. However, success in one area does not always equate to success in another. For instance, a company may be profitable yet still lack sufficient available cash to cover essential expenses, such as payroll or supplies, especially if it is waiting for customer payments or has not yet sold its inventory. In this case, profitability does not necessarily mean positive cash flow, and cash flow becomes a more critical figure for stakeholders.
Similarly, a company may temporarily enhance its cash flow by securing loans or selling assets. However, if its earnings are not adequate to generate profit, achieving profitability becomes increasingly crucial. Therefore, it is vital for companies to achieve profitability to ensure their ongoing operations.
Conclusions
Nintai is not entirely averse to using net income/earnings to evaluate a holding. Free cash flow is a more applicable measurement tool because cash is king. Our results in the 2007-2009 Credit Crisis have further strengthened FCF’s appeal in our research and valuation methods. We should note that this can require considerably more research time as we convert a company’s quarterly earnings report into a free cash flow quarterly report. But we think the effort is worthwhile.
FCF represents excess cash generated by a company that is available for distribution to investors, debt repayment, or reinvestment in the business. Because of that, our role as a shareholder and fiduciary for our investment partners means we are acutely interested in how cash will be deployed. If a company can achieve greater returns on invested capital by deploying funds toward strategic acquisitions or expanding existing operations, then we fully support such efforts. However, this is only if those returns exceed what Nintai, or its investment partner, can achieve independently. If the latter is accurate, we would like to see the capital deployed in the form of dividends. Additionally, if the company’s shares are trading at a significant discount to our estimated intrinsic value, then share buybacks might be the best use of cash. Free cash flow can assist us in any of these calculations where net income might not provide us the insight to recommend them.
For all these reasons, in addition to the previous analysis of FCF compared to earnings, we dedicate a significant amount of time to examining a holding’s FCF figures. We believe that, over the long term, a company’s share price will closely follow its free cash flow numbers.
I hope this provides you with a solid overview of why our valuation spreadsheets, along with many other documents, use FCF as a fundamental measure. Please don't hesitate to contact us with any questions or comments. My best wishes.
DISCLOSURE: Nintai Investments does not own shares in any company mentioned in this article.
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