Reconciling cash flows and net profit

One of the first thing we learn about investing is the price to earnings ratio. Analysts spend a great deal of time trying to forecast earnings and whether companies meet analyst expectations of earnings tend to move stock prices in the short-term. What is however surprising is that valuation models of companies use cash flows and not earnings. Thus, its cash flows and not earnings that determine the value of companies.

With this thought I tried to refresh my knowledge of  accounting. We can start with Net Profit. The Net Profit of a company is based on the accrual system. This means that if I have sold something to a customer but am yet to receive the cash this is still recorded as a revenue. The accounting system starts with Sales revenue and removes all expenses (cost of goods sold, selling and marketing costs, interest payments and taxes) to get to the Net Profit. The Net Profits cash flow counterpart is the Cash Flow from Operations. Increasingly I am coming to believe that CFO is a better tool than Net Profit. So let us first reconcile these two.

Net Profit = Sales – Cost of goods sold – Selling, General & Administrative Expenses – Interest Expense – Taxes

CFO = Net Profit + Non cash items (Depreciation & Amortization) – Working Capital Investment

So as per the formula, there are a few differences. First we add back non-cash expenses to Net Profit. These items include depreciation, amortization, deferred taxes etc. We then adjust for investments in working capital. For most companies CFO is lower than Net Profit mostly due to investments in working capital. In a few rare occasions they can be higher or equal. These are the cases where using Price/CFO is a better tool than Price/Earnings. The cases I have seen this happen are businesses where companies have a negative working capital cycle (they collect revenues in advance and/or can delay payable for a long time). In one case I have seen a company use a very accelerated depreciation method which artificially reduced accounting Net Profits.

The other cash flow term analysts love is Free Cash Flow (FCF). FCF is very similar to CFO but has two major differences. First it excludes interest expense and excludes any tax benefits due to interest. Secondly we have to remove investment in fixed assets because those are investments in the future. The free cash flow can be  calculated using a number of methods. Two of them are given below.

FCFF = CFO + Int*(1-taxes) –  Capital Expenditures

FCFF = EBIT*(1-taxes)+D&A – Working capital investment – Capital Expenditures
This brings another dimension to our analysis. Businesses which need a lot of investments to sustain or for capacity additions are inferior to businesses that don’t. They will have a lower FCF compared to better businesses all other things kept constant. Therefore, by using Price/FCF instead of Price/Earnings or Price/CFO we can further refine our analysis. We however need to be careful because sometimes companies can have big lumpy investments that can take FCF to negative territory. One way to resolve this is to only consider maintenance capex (exclude expansion capex) while calculating free cash flow. Alternately one can forecast normalized FCF and use those numbers to judge the business.
Having a clear concept of accounting has a lot of benefits in the investing business. It helps us find investment opportunities by looking at the same business in a different angle. While I still use Price/Earnings as a easy method of idea generation, occasionally I have used both Price/CFO and Price/FCF to generate investment ideas.

Asif Khan, CFA

Asif Khan is presently a Research Analyst (Financial Sector) for Exotix which is a frontier market focused investment bank. He has more than 6 years of work experience as equity analyst in both buy and sell side roles across Asian frontier markets. Asif is a CFA Charterholder and has a dual major in Finance & Economics from North South University.

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