Cash Flow vs. Earnings: Which Is More Meaningful?

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Cash Flow vs. Earnings: Which Is More Meaningful?
by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research
September 18, 2006

Investors often hear analysts and money managers argue that cash flow is a more useful metric of investment attractiveness than earnings. This argument begs several questions, which we'll tackle one-at-a-time.

How do earnings and cash flow differ from one another?
In a very simple business, a firm would receive revenue by selling some type of good or service. The firm would then total up the costs of providing that product—costs being expenses such as labor and raw materials. The difference between the revenue received and the costs incurred would be the firm's net income or earnings. If the firm received immediate cash payment for its sales and immediately paid cash for its costs, its earnings and cash flow would be the same. But this is not how the real business world works. Earnings and cash flow vary because of the way accrual accounting treats timing differences between business actions and cash movements:

First, there are often short-term timing differences between when a firm records sales and expenses versus when the firm actually receives and pays out cash.

For example, if a firm sells a product but lets the customer pay over time, the sale is immediately recorded as revenue and this sale would generally have a positive impact on earnings. But since no cash was received, this sale would not affect cash flow. Later when the firm received a customer payment, that payment would have no impact on earnings, but would increase cash flow.
Second, there are timing differences between a firm's cash outlay for long-lasting assets such as buildings or equipment and when the firm is permitted to expense these assets.

For example, if a firm spends money to build a factory, the entire cash outlay reduces cash flow but would have no immediate impact on earnings. Later, as the firm is allowed to depreciate the cost of the factory over time, the depreciation expenses reduce earnings but have no impact on cash flow.

How is cash flow calculated?
This is where investors must be careful when doing research, because there is no standard definition of the term "cash flow". A particularly common and, I believe, misleading definition is to start with net income and then add back all expenses for depreciation, amortization, and depletion, since these are expenses that did not require the firm to outlay cash. Let's call this definition "simple cash flow". The problem with simple cash flow is that it fails to account for the fact that a firm must outlay cash to replace its capital investments as they depreciate over time. For example, cable companies are notorious for trumpeting themselves as prodigious cash flow generators, at least in terms of simple cash flow. But cable companies also require enormous capital expenditures to keep their networks up-to-date.

We believe a much more meaningful definition of cash flow is to derive what is known as "free cash flow". In its most basic form, free cash flow starts with simple cash flow, i.e., earnings plus depreciation, but then subtracts out capital expenditures. The concept of free cash flow measures what a firm has left over after it has paid all its operating expenses and has also outlaid necessary cash to keep replenishing its factories, equipment, etc. as they wear out. A firm with negative free cash flow may have to borrow money, issue shares or cut back operations to stay viable, whereas a firm with positive free cash flow has the means to pay dividends, pay down debt or buy back shares.

Why might cash flow be more important than earnings for analyzing a stock's investment merits?
Since earnings and cash flow differences stem from timing, in the long run these two measures must converge, but over shorter time periods the degree to which they differ provides the analyst with critical information about the nature of a firm's operations. Let's consider a few examples.

Imagine a growing firm that has to spend cash to buy costly equipment needed to manufacture an innovative new widget. The hope, of course, is that the capital investment will pay off in future widget sales, but common sense tells you that spending money now in the hope of a future payoff is risky. If you looked at this firm's current earnings, they wouldn't be impacted by this risky capital expenditure. But cash flow analysis would reveal the negative impact on cash flow of this capital investment. Investors are often fooled by the high reported earnings growth of rapidly expanding firms—the retailing industry provides many examples of hot stocks that later collapsed. The problem is that the cash outlays generally required to keep building new stores or restaurants only gradually show up in reported earnings via depreciation, making these growing retailers look much more profitable than they really are.

Imagine another firm that decides to begin offering credit to its customers to encourage them to buy more product. If the firm's move resulted in an increase in sales, it is likely that this would show up as an increase in reported earnings as well. Only cash flow analysis would reveal that the firm's customers had not yet actually paid for the new sales. Lucent Technologies is an example of a company that investors once loved for its steady earnings growth, but investors ignored the fact that Lucent's cash flow was not growing at nearly the same rate as its earnings. Eventually, Lucent's stock price dropped significantly during the tech stock collapse of 2000-2001, in part because the customers to whom it had extended credit were unable to pay for their purchases.

I could provide more examples, but there are two important insights investors should take way from this article.

Beware of any firm with negative free cash flow, even if reported earnings are positive.
Beware of any firm whose reported earnings exceed the cash flow they are generating from operations.

How can Schwab clients benefit from cash flow analysis?
First, understand that publicly traded firms are required to report all the data you need to analyze earnings and cash flow in their quarterly and annual financial statements. Earnings information is found in the Income Statement and cash flow information in the Statement of Cash Flows. Most firms make their shareholder reports and more detailed versions, known as 10-Q and 10-K forms, available on their corporate web sites. For Schwab clients, extensive earnings information is available on schwab.com under the Quotes & Research tab. Cash flow information is less readily available (which, by the way, contributes to its potential value !) All Schwab clients have access to cash flow data in the S&P Stock Reports, and more extensive cash flow data from the Reuters ProVestor Plus reports.

Of course, even with cash flow data in hand, there's one remaining problem—how can you best interpret this data to make informed investment decisions? Thankfully, Schwab offers a good solution to this dilemma—the Schwab Equity Rating! Underneath the Schwab Equity Rating grade is extensive cash flow and earnings analysis, based upon the specific measures our historical research has determined to be most correlated to subsequent stock returns. Of course, Schwab Equity Ratings also incorporate other fundamental, valuation, momentum, and risk measures to arrive at a rating of current investment attractiveness.

What's most useful?
So let's go back to our original question—is cash flow more useful than earnings? We believe that there is no reason to choose one over the other. Schwab research has found both measures to be important, and certainly any investor who has paid attention only to earnings will benefit by adding cash flow analysis to his/her investment toolkit!

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