Analyse your stocks in seconds
Expert insights you can understand
Improve the odds of your stock picks
Generate investing ideas fast
Track & improve your Portfolio
Time your trades better with charts
Explore all the featuresStockopedia contains every insight, tool and resource you need to sort the super stocks from the falling stars.
One time I accompanied a senior analyst to meet the chairman of a company that was rolling out new units at pace. I was just out of university and what little knowledge I had of business came straight from the textbook. This was maybe my first chance to listen to actual professionals talk about the reality of running companies.
For the most part, I sat to one side, wide-eyed, watching the conversation like an owl and scribbling all manner of notes into my little book. Beneath the busyness, I was just happy to be in London, out of the office, and with someone else paying for my lunch.
The details of this meeting have faded with time but one exchange, which I’ll paraphrase, seems to stick. Towards the end of the lunch, the chairman turned to me and said: 'You’ve been quiet. You must have a question for me.'
I had several hundred, but I settled on one.
'With all these new sites, all these pre-opening costs and adjustments, which numbers do I look at to understand what’s really going on?'
To this, the chairman replied, 'Cash is king' - so I took his advice and checked the cash flow statement.
For investors wanting to hone in on the underlying picture, being able to navigate a cash flow statement is a must. Adding even just a few cursory cash flow quality checks into your investment routine - such as making sure that cash flow from operations routinely covers capital expenditure and dividend and interest payments - can help reduce risk substantially.
You can find my quick take on a cash flow checklist at the bottom of this article.
The cash flow statement should be evaluated within the context of the company’s industry and its corporate lifecycle.
Certain industries are capital intensive, like hotels, while others chuck off so much cash they don’t know what to do with it. All else equal, a cash generative company or sector will command a higher valuation multiple than one that requires vast amounts of capital expenditure - so this is an important business characteristic to be aware of.
Take two companies with roughly the same market capitalisation in different sectors, with vastly different cash flow characteristics: Restaurant Group (Hotels & Entertainment Services) and EMIS (Healthcare Equipment & Supplies). You can see their standardised cash flow statements by clicking on the ‘Cashflow’ link at the top right of the ‘Financial Summary’ sections of their StockReports.
We see that Restaurant Group has to spend a lot of money to keep its casual dining estate in good condition.
In fact, more often than not, the majority of cash flow from operations will have to be reinvested into the group’s estate. This reduces Restaurant Group’s scope to use that cash for promising investment opportunities or to return to shareholders. Considering it still pays out £35m a year in cash dividend payments, the group might be better off cutting its dividend so it could redirect this money back into its turnaround strategy.
EMIS’ six-year cash flow statement looks much different:
We can see that these two companies are valued very differently by the market. Admittedly, there are other factors at play here, but the Quality Ranks, Return on Capital percentages, and valuation multiples are no coincidence:
In terms of the corporate lifecycle, start-up companies typically lose cash in their early years and need to raise funds periodically. Understanding cash burn is important here.
Simply calculating how much money a firm is losing in cash flow from operations, and comparing that to the amount of cash it has on its balance sheet, can give you a reasonable impression of whether or not a fundraising is on the cards. Knowing this can give you an edge and help inform your investment decisions.
An example of the former might be something like Gfinity, whose negative Cash from Operating Activities has so far been funded by periodic injections of new equity funding in Cash from Financing Activities:
So, Gfinity has had to raise millions of pounds every six months for the past two years or so. This dilutes existing shareholders who do not take part. We can compare this track record to the amount of cash currently on the group’s balance sheet and conclude that Gfinity may need to raise cash again before its forecast breakeven point in 2021 if further investment is required:
Gfinity might be able to see itself through to breakeven after this latest placing, but it is far from guaranteed. This is in contrast to a more mature, cash-generative company like IG Group, which has reached a point where it routinely generates enough surplus cash to cover capital expenditure costs, pay out a dividend, and buy back shares.
Start-ups generally depend on positive cash flows from financing activities to fund operating losses as they pursue profitability. Mature companies tend to have reached this point of sustainable profit and generate enough cash from operations to fund negative financing cash flows (dividends and buybacks).
Operating cash flow is less easily manipulated than operating or net income. For this reason, significant and persistent differences between operating cash flow and earnings can indicate low-quality earnings and even earnings manipulation. That said, there is a degree of subjective judgement involved in these statements.
By timing transactions in a certain way, a company can boost its cash flow from operations.
An example of this is might be a company that sells receivables to a third party and/or delays paying its payables. Such management choices to decrease current assets or increase current liabilities (choices that will increase operating cash flow) can be detected by looking at activity ratios, changes in balance sheet accounts, and disclosures in notes to the financial statements.
The classification of cash flows is another area open to the subjective judgement of management. It’s possible to shift positive cash flow items from investing or financing activities to operating activities to inflate operating cash flows.
Under International Financial Reporting Standards (IFRS), for example, interest paid on debt can be classified as either operating or financing cash flow. Interest and dividends received can be classified as operating or investing - so an IFRS-reporting company that changes dividends received from investing to operating cash flow would be able to boost the latter.
Classifying securities as either trading or non-trading also allows a degree of control over whether these cash flows are classified as investing or operating.
For established companies, high quality cash flow typically has the following characteristics:
People looking for a quick ‘due diligence’ cash flow checklist could incorporate something like this into their analysis. A bonus check, which is a more general look at earnings quality and cash generation, might be to look at whether cash flow from operations regularly equals or exceeds net income.
About Jack Brumby
I'm looking for compounding investments.
I started off in Leisure - a part of the market I still love, but an area where stocks can appear "cheap" for years without going anywhere. It made me realise that valuation is only one part of the puzzle.
Now I sift through a much broader universe of stocks in search of small, high quality operators with large addressable markets, strong and maintainable margins, and clear share price catalysts.
CFA charterholder.
Disclaimer - This is not financial advice. Our content is intended to be used and must be used for information and education purposes only. Please read our disclaimer and terms and conditions to understand our obligations.
I like to split the capex into 'maintenance capex' and 'expansionary capex'. Roughly, for a company with short duration assets, the depreciation ought to be equivalent to the maintenance capex. So if I subtract that from the capex number it gives a rough idea of how much the company is investing in future growth.
Obviously for longer duration assets one needs to make a guesstimate for how much 'inflation' adjustment needs to be made.
Maintenance capex SHOULD be the capex spent to maintain the economic earnings power of the business - rather than just a purely mechanical calculation. A classic example of this occurs when one considers computers - a business might have bought a computer 5 years ago for £1000. Today they have replace it with a £300 computer. For certain areas that is the appropriate replacement or maintenance capex. But in other parts of the business to maintain the same market presence the company actually needs to now spend £1500 (because competitions have moved on to new fangled advanced mobile devices etc) for the business to maintain the same economic earning power.
One of the issues I have had with retailers such as M&S is that I have felt for a long time that they have underinvested in their store assets --- it is hard to prove that from a balance sheet but a walk around some of their stores reveals old / non-functioning lights, floor tiles with marks or breaks, safety tape on the floor etc. All of these are, to me, signs of a business that has underinvested in 'maintenance' capex.
In the old days companies used to have 'sinking funds' to build up their reserves for major replacement purchases - I think that is still a useful way of thinking about maintenance capex.
Thank you Jack for some explanations on where to look and why. I find the cashflow statement the most difficult to follow of the three consolidated statements in company results.
I know to look for various measures, especially whether cashflow per share is out of kilter with earnings per share, but to be given some advice in plain English on different cashflows expected for different types of business as well as boring down a little deeper into what the different sections of the cashflow statement represent and how even these can be tinkered with is a big help.
It is all well and good being given information on what to invest in by advisers, but it's being able to fend for oneself when analysing a company that really matters to me.
It's the Why not the What that I enjoy learning!
Santa
P.S. Actually I enjoy learning the What as well, but I feel that, like 'cash', the Why is King!
It may be very crude and basic but taking the cash shown on the balance sheet and comparing it with the interest received on the cash flow statement can present a good guide as to the accuracy of the former. Fiddling the cash displayed on the balance sheet is not difficult to do. But it's more onerous fiddling the interest received. They may not tally precisely and, obviously, there are timing issues and fluctuations in interest rates. However, over the long-term, a correlation is probably to be expected.
Agree with comments about maintenance Vs expansionary & checking against interest received.
Ditto personal checking where possible eg the estate for retail etc.
Important to remember that the balance sheet is on only one day and the average balance sheet may differ.
It's important to realise that you can't get it all from the figures. You need to understand what the figures are portraying, which means understanding how the business (& industry) functions and when something looks out of line. You either have that from experience or you can be taught some of it, but it's not something you'll often see on an investor site. That's one of the advantages of being able to see some of Paul's analyses.
PS I think it's misleading to look at the gross Restaurant (LON:RTN) figures. Vital to split it into components, and also vital to go much further back.
Similar issues to Tesco, which looked good on the surface but had been squeezing the pips too hard for too long. And M&S which had good cash generation but was underinvesting on its estate (quite reasonably imho - there wasn't enough evidence that investing in its estate would be profitable)
It's also important to remember that mature businesses ought to be throwing off cash and immature businesses will need it. Some companies are a mix of the two.
The most important aspect of analysing a mature business is to work out the end game. What are the wind up costs? Will that generate money, will that eat money, when will it run out of road completely???
This the bit that Philip Green got completely wrong. His businesses were going to eat money at the end (pensions), property was becoming a cost not an asset and the cash flow was declining. He should have sole 3 or 5 years earlier when there would have been buyers at decent prices.
Hello John, I have printed below the quick comparison I make;
My confidence to invest in a share reduces proportionally with the number
of years in which Normalised eps exceeds Op. cashflow. One year is probably OK
but more than 3 is pretty much a red flag for me.
So for me, the above stockreport from Bloomsbury Publishing (LON:BMY) is fine as Op. cashflow
is only materially lower than eps in one year, and comfortably exceeds or equals
eps in the other years. That said if a company I already own throws in a
year of poor Op. cashflow then I will scrutinise particularly carefully for
other signs of weakness e.g. order backlog flat or ambiguous outlook statement.
Like other investing techniques I think Op. cashflow vs eps works well with other risk factors.
One situation where I have found it useful is high growth stocks/tips where management are portraying a breakthrough technology or hot retail concept. With these I might put them on the watchlist if I like the story but I don't invest until there is a record of good Op. cashflow vs eps. A good example of recent years where I avoided disaster using the screen is Tungsten (LON:TUNG).
It also sometimes works when 'official' growth stocks start to run out of puff. Here I use it with stocks I already hold e.g. Ted Baker (LON:TED) which used to have beautiful Op. cashflow vs eps that has turned patchy in recent years with debt rising and outlook statements becoming more and more laboured.
I should explain that my style of investing is primarily 'story' based and I get my investment ideas from thinking about obvious global trends in conjunction with independent research of the company's products, competitive position and management track record - I don't have the type of brain required for detailed analysis of cashflow and balance sheets. That's why I find Op. cashflow vs eps so useful because it's a quick shortcut to eliminating loads of shares I might otherwise waste time or money on.
However I am sure some Stocko subscribers do have those accounting skills and as such can dig beneath the headline numbers and satisfy themselves as to whether a share has legitimate reasons for eps exceeding Op. cashflow. A good example of where the screen doesn't seem to work is Bioventix (LON:BVXP) (see below) which has been a fantastic investment for those who have the accounting skill to get behind the headline numbers.
Can anyone tell me in lay persons terms how/why bvxp manages to report rising eps, divi and sp with Op. cashflow consistently and significantly trailing eps?
Hi HHR,
Interesting points.
With regards to Bioventix (LON:BVXP) , from a superficial look it appears to me that cash has been absorbed into working capital (although I'm struggling at first view to see just how Stocko have derived these numbers).
It is fairly common for a growth company to soak up cash into not just Capex but also working capital, so I would not see that as a red flag as such (although worth a check that the WC is proportionate). Just a quick superficial view, but as top line growth moderated in 2018, you'll see that OCF / share exceeded EPS, suggesting that indeed all is well with that measure.
I think you do have to contextualise the Cashflow with where a company is in it's growth cycle.
Even for the seasoned investor, this presentation given by Tim Steer, former UK equities fund manager for Artemis, at the recent UK Investor show is definitely worth viewing. He clearly and concisely highlights many of the red flags associated with failing companies and gives particular attention to the importance of cash. If saving money equates to making it then the time spent viewing this is probably one of the better investments one can make.
https://www.ukinvestorshow.com/videos/tim-steer-spotting-red-flags-from-quindell-to-patisserie-beyond/
I'm not at all confident in this , and don't have time to double check right now but I think Bioventix (LON:BVXP) might be down to it's royalties where they are earned in a period but paid in cash in arrears, maybe twice annually I seem to remember?
Happy to be corrected, or even shot down for this as it's not my strong suit either.
*Past performance is no indicator of future performance. Performance returns are based on hypothetical scenarios and do not represent an actual investment.
This site cannot substitute for professional investment advice or independent factual verification. To use Stockopedia, you must accept our Terms of Use, Privacy and Disclaimer & FSG. All services are provided by Stockopedia Ltd, United Kingdom (company number 06367267). For Australian users: Stockopedia Ltd, ABN 39 757 874 670 is a Corporate Authorised Representative of Daylight Financial Group Pty Ltd ABN 77 633 984 773, AFSL 521404.
I totally agree with you about operating cashflow vs earnings. This quick measure is in the Zulu Principle and over the years it has really worked well for me in avoiding disasters.