You see it in financial media all the time “ABC company is trade at a P/E of #!” When the P/E isn’t being trumpeted directly it is the modified “CAPE (Shiller P/E).” This Lizard King has a secret for you though. “Earnings” at a publicly traded firm is actually a very mushy number. I spent about 7 years in the SEC reporting department of a multibillion dollar publicly traded firm before getting my lizard on. And I learned there are a lot of levers management can have the accountants pull to make the Net Income line tell a story.
I’ll save the gory details except to say the two most widely abused accounts are Accounts Receivable and Inventory. (I’ll tell you how to correct for any such manipulation soon.) And for those of you who would like to deep dive into the topic, I recommend Thorton L. O’Glove’s book “Quality of Earnings.” Glove breaks down into simple prose 12 topics over a quick 188 pages the high points of accounting chicanery.
So how do you come up with fair value for a company if the P/E ratio has to be looked at skeptically? The simple answer is to get friendly with the Cash Flow Statement. There are three main statements in accounting. The Income Statement and Balance Sheet get all the glory but it is Cash Flow that tells us the most about the health of a company and its operations. Importantly, the levers that accountants can pull to artificially inflate earnings, especially on the Receivables and Inventory side, will leave a telltale sign in the Operating Income portion of the Cash Flow statement.
See the CFS has three sections. The first is the most important to raptors looking to find cash gushing businesses to safely write options on. That is the Cash Flows from Operations section. The first thing this section does for us is back out the (usually) large non-cash Depreciation line item. After that, it settles the score on changes in Receivables, Inventory (there those two tricky fellas are again!), and Liabilities. This leaves us with the actual change in cash that resulted from the firm’s primary business activities. To make things simple, more Operating Cash Flow is better!
The second section is Investing Activities. The most important line item here is Capital Expenditures. This is the money the firm spends to maintain its plant and equipment and to expand operations. When we deduct Capital Expenditures from the Operating Cash Flow from above, we get a very special measurement known as Free Cash Flow (FCF). This is arguably the most important number in finance but it gets little airplay. In most cases, the best way to determine if a company is under or over valued is to compare the Price to Free Cash Flow ratio to the historical average for the industry. We want to buy when the ratio is “low” and sell when it is “high.” Most financial media will tell you to buy when P/E is low (and vice-versa) but they do not warn you that the Earnings portion of your valuation could be very suspect! The FCF number on the other hand, is very difficult to manipulate.
I’ll offer a bonus morsel for the Dividend Investors out there. In the third section of the Cash Flow Statement (the Financing Section), we find the cash outlay for Dividends Paid. Probably the best way to determine if a dividend is sustainable is to get the Payout Ratio which is Dividends Paid divided by Operating Cash Flow. Low ratios suggest operations is generating enough funds to pay the dividend going forward. Ratios over one tell you a dividend cut is imminent! Don’t get caught be surprise by a company with a high payout ratio.
Devour your prey, raptors!