Cash: The exiled king?

In a recent survey, corporate executives noted earnings are a simple metric that summarize performance, get broad media attention, simplify analyst communication, and appear to be the basis of analyst evaluation. Further, nearly 80 percent of the executives said they would be willing to forgo a value-creating project in order to present smooth earnings.

One catalog of sell-side analyst reports shows that 99.1 percent mention earnings and price-to-earnings multiples, while only 12.8 percent use some variation of discounted cash flow to derive target prices².

“Cash is a fact, profit in an opinion.¹“
– Alfred Rappaport
Creating Shareholder Value

Earnings often provide an incomplete, and in some cases distorted, view of a company’s economic condition and prospects³. The choice boils down to one between convenience and relevance. Here are three differences between economic and accounting results:

1. Companies can compute earnings using alternative and equally acceptable accounting methods.
2. Earnings exclude incremental capital needs, including the working capital and capital expenditures companies require to grow sales and profits.
3. Earnings do not consider the cost of capital. As a consequence, there is no reliable link between earnings per share growth and the creation of shareholder value.

Companies still have substantial latitude in the accounting methods they select. Examples include depreciation schedules, loss reserves, and methods of recording inventory costs. In theory, two companies with identical economics can have very different bottom lines based on the accepted accounting choices they make.

More concerning, earnings do not consider future capital needs. For instance, many companies require higher levels of inventory and accounts receivable as they grow. These working capital investments are true cash outlays that earnings do not reflect, leading to a potentially meaningful gap between earnings and cash flow. Earnings also do a clumsy job of reflecting capital expenditures. Companies record their capital expenditures on the balance sheet and depreciate them over the asset’s estimated useful life–itself a judgment call. So to go from earnings to cash, investors must add back non-cash depreciation expense to earnings but must then reduce earnings by the amount of the capital expenditures.

Finally, earnings do not consider the cost of capital. Companies can make investments that add to earnings per share but fail to create value. This is particularly important today as current financial stress has increased the cost of capital.

A number of significant corporate finance activities present the opportunity for divergence between earnings growth and value creation. These include mergers and acquisitions, share buybacks, and capital projects funded with internally generated cash flow.

Watch the hips

Investors and companies often point to the popularity of earnings as prima facie evidence of their relevance. And, of course, earnings are relevant to the degree they are a reasonable proxy for cash flow. The crucial question is how the market reacts when earnings and cash flow diverge. To answer, we can set aside opinion and see how the market responded in specific events that led to a divergence between the two.

One of the first studies on the topic was conducted in 1973 by economist Shyam Sunder, who looked at what happens to stock prices as companies shift from first-in, first-out (FIFO) to last-in, first-out (LIFO) accounting during a period of rising prices. Companies electing that shift see a decline in earnings because reported expense rises, but an increase in cash flow because cash taxes are lower. Sunder showed these companies also saw their stocks rise–net of market changes–in defiance of a simple earnings-based model⁴.

This and other studies strongly suggest the market looks past simple earnings measures⁵. These findings appear to be valid through time and over varying circumstances.

What do the numbers tell us today?

To show the difference between reported earnings and cash flow, we reconciled the operating net income and cash flows for the companies in the Dow Jones Industrial Average (DJIA) over the past decade (1998-2007). We define cash flow as the difference between cash flow from operations and capital expenditures. Highlights include:

• Cash flow was 96 percent of operating net income on a weighted basis. This ratio continued to stay above the levels of the late 1990s but is below the 2002–2005 levels. We also observed a wide range of cash flow-to-earnings ratios, with ten-year averages ranging from roughly 20 percent to over 150 percent. This disparity underscores that what you see may not be what you get.
• Capital spending rose 11 percent. This was the third consecutive year of double-digit capital spending growth. The pickup in capital expenditures is the primary reason the cash flow ratio is lower today than the early 2000s. During the post-bubble bear market, companies were very tight with their purse strings. The current challenging economic environment will likely lead to slower capital spending going forward.
• Total debt increased 10 percent, and the cash flow-to-debt ratio rose slightly to 51 percent from 50 percent in 2006. In the early 2000s, this ratio was consistently in the mid-30 percent range. The balance sheets of these large companies remain in excellent shape, in contrast to the woes in the financial sector.
• Working capital grew moderately at 7 percent, although the range of change was also quite wide. Some companies saw multi-billion dollar swings that earnings did not capture.

Cash flow in a knowledge economy

The classic definition of free cash flow is net operating profit after tax less investment needs, including working capital changes and capital expenditures.

As our global economy migrates away from manufacturing toward service and knowledge businesses, the accounting for investments is a lot less tidy.

Take Microsoft as an example. In fiscal 2007, the company spent nearly $7.1 billion on research and development–certainly a form of investment–and only $2.3 billion on capital expenditures. Microsoft is making healthy investments in its business, but most of those investments show up on the income statement as an expense, versus on the balance sheet as an asset.

Understanding the nature and potential payback from intangible investments is more important than ever. Today’s accounting conventions, developed to capture the condition of largely tangible-asset businesses, do a substandard job of capturing the essential features of intangible investments⁶. Additionally, since the investments of intangible-centered companies tend to appear as expenses on the income statement, these companies frequently generate high cash flow-to-earnings ratios. To illustrate this point, we selected two groups of companies to represent tangible and intangible businesses and compared their cash flow-to-earnings ratios. (See Exhibit 1.) The intangible group generally shows higher cash flows for each dollar earned than the tangible group, although that trend reversed slightly in 2007.

Cash caveat

The cash flow statement is not immune from manipulation. Accounting divides this statement into three components: cash flow provided or used by operating activities, investing activities, and financing activities. Analysts and investors generally view cash flow from operations as recurring, and therefore as a signal of a company’s earnings power. Problems arise when companies falsely classify certain items in order to make their cash flow from operations higher, while keeping total cash flow the same. For example, a firm may classify certain operating expenses as investing or financing items, or conversely, classify investing or financing inflows as operating.

What you see and what you get

This discussion yields some relevant conclusions for investors:

• A company’s value equals the present value of future cash flows. It is cash flow, not earnings, that ultimately determines value.
• Earnings are severely limited. Specifically, companies can calculate earnings with alternative acceptable approaches, earnings neglect capital needs, and companies can grow earnings without creating shareholder value.
• Empirical evidence suggests the market looks through earnings. Event studies suggest when there’s a dichotomy between earnings and cash flow, the market generally follows cash. This undermines the view that the market simplistically capitalizes earnings. Further, investors are better off gauging a company’s ability to return cash to shareholders via dividends and share buybacks using cash flow rather than earnings.
• An analysis of the DJIA suggests cash flows remain very healthy. However, a large dispersion exists behind the aggregates, suggesting investors should do in-depth company-by-company analysis. Further, the current challenging economic situation will penalize earnings for the foreseeable future. Consequently, a focus on cash is more important than ever.
• The ongoing shift to an intangible-based economy renders earnings even less useful. Comparing two companies with similar earnings but different business models is potentially extremely misleading.

This article originally appeared in Mauboussin on Strategy, a Legg Mason Capital Management (LMCM) publication, in November 2008. It has been summarized by Irene Goryn, CFA, and printed here with explicit permission of LMCM.

¹ Alfred Rappaport, Creating Shareholder Value: A Guide for Managers and Investors (New York: Free Press, 1998), 15.
² Paul Asquith, Michael B. Mikhail, and Andrea S. Au, “Information Content of Equity Analyst Reports,” Journal of Financial Economics, Vol. 75, 2, February 2005, 245-282.
³ Alfred Rappaport and Michael J. Mauboussin, “The Trouble With Earnings and Price-Earnings Multiples,” www.expectationsinvesting.com, September 2001.
⁴ Shyam Sunder, “The Relationship Between Accounting Changes and Stock Prices: Problems of Measurement and Some Empirical Evidence,” Journal of Accounting Research, Vol. 11, Empirical Research in Accounting: Selected Studies, 1973, 1-45.
⁵ There is some evidence the market doesn’t see through all earnings manipulation. See Scott A. Richardson, Richard G. Sloan, Mark T. Soliman, and Rem Tuna, “Accrual Reliability, Earnings Persistence and Stock Prices,” Journal of Accounting and Economics, Vol. 39, 2005, 437-485.
⁶ Baruch Lev, Intangibles: Management, Measurement, and Reporting (Washington, D.C: Brookings Institution Press, 2001). Also, John Hand and Baruch Lev, eds., Intangible Assets: Values, Measures, and Risks (Oxford: Oxford University Press, 2003).