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"To everything there is a season, a time for every purpose under the sun." ecclesiastes 3:1-8

While sharing my last article on Facebook (NASDAQ:FB) with friends and family, it occurred to me that some of those who are gracious enough to read my articles are not familiar with my valuation metrics. For this article, I'm going to take a few steps back from my recent valuations to focus on the "why" I use some of the metrics I use, while taking the time to define relevant terminology. For those of you who ARE familiar with these concepts, please feel free to keep me honest in the comments section, and provide feedback, as a good deal of this article will be opinion on methodology. Additionally, if you'd like to see how I evaluate a stock in detail, I've conducted detailed analysis here and here.

School of Thought

There are as many schools of thought on investing as there are pundits to peddle them. Groups of investors congregate around their chosen doctrine, and often they defend it with unrelenting zeal. A popular school of thought revolves around earnings. Earnings have their place, and I don't outright reject them. But like everyone else, I have my own doctrine. Mine isn't unique, and its followers aren't exactly few in number. But I think it's worthy of explaining why I think my way of evaluating stock value is the doctrine you should prescribe to.

Earnings, Earnings, Earnings!

When I read articles on Seeking Alpha (and elsewhere), I cringe to see valuations based solely on Earnings per share (EPS) or Price/Earnings (P/E), all derivatives of Net Income. In simple terms, net income is revenue - expenses. Expenses include Cost of Goods sold, taxes, interest expense, and depreciation. Companies are required to report net income based on GAAP accounting (Generally Accepted Accounting Principles), which also means they use accrual accounting. This means that expenses must be matched with the revenues they ultimately generate. So if ACME Coyote Catapult Co [ACC] purchases $200K worth of material to build its new Canine Strato-launcher, net income is not going to reflect the expense until some unfortunate varmint purchases the device.

Using net income derivatives has some substantial advantages. First, earnings, earnings per share, and P/E are nearly universal. All of these numbers are prominently reported in the financial media, and on financial websites. Analysts estimate growth rates for earnings and base buy and sell calls heavily on whether their expectations are met or not. It's very safe to say that, in the short term, earnings drive stock prices.

Second, because earnings usage is universal, and because GAAP requires that net income be reported, it is the most accessible version of profitability. Anyone who has Internet access, can type, and can divide, can find the net income line on an income statement and divide it by the "number of shares outstanding" line to find EPS. Divide current stock price by this number and you now have P/E. Since this is done by almost everyone already, there really is no need to go to even these lengths. Simply copy and paste from Yahoo finance, or Finviz and you are done.

Finally, earnings are smooth. Large expenses are smoothed out through depreciation (dividing the cost of a project across an estimated useful life, or a time period allowed by accounting rules). COGS (cost of goods sold) is matched with revenue, so that large upfront costs don't bring down Net Income one year, and cause a jump the next. GAAP rules give some lead-way on what is reported in what categories, and to some degree when it is reported. So other expenses and events can be massaged by management to avoid market shocks.

You may notice that within each of these "advantages," there is the seed of discord. Yes, EPS and P/E are universal, but that only means there is less room for disagreement. Earnings are available to everyone, and it takes no work to determine whether a stock has a low P/E or a high P/E. We all know that the "devil lies in the details," but it's tempting to build an information bias based on this first glance. If we have made up our mind that this "stock is cheap," then we are subsequently likely to filter all negative data as unimportant, and all positive data as substantial. Thus a useful shortcut in finding value can become a trap if we are not careful.

Worse, universal earnings usefulness provides management with incentive to focus on meeting earnings hurdles, set by themselves, analysts and public perception. Meeting these goals may sacrifice future profitability or exploiting legal (or illegal) accounting "shenanigans" to put on the best face. For instance, simply choosing different methods of depreciation (three different types are allowed by GAAP), or choosing a different useful life for a depreciated asset can yield significantly different results.

Below, I depict our company of interest versus its near-peer competitor Aerial Marsupial Catapult Co [AMC]. Both companies recently invested in a TNT assimilator device, costing them $1000. ACME Coyote chose to go with the industry standard estimate of a 20-year life for the device, but Aerial Marsupial built an argument for and ran with the assumption that it would gain 25 years of life from the device. Both are otherwise identical companies, but AMC comes out with better earnings for the year.

(click to enlarge)

With both companies deviating by only 7.5 cents, one may argue that there is very little difference. But in one case, we have a P/E of 16.67, and in the other case we have a P/E of 14.8. AMC seems significantly cheaper. We can hardly blame the casual value investor, who wants a cut of the lucrative mammal catapulting industry to choose AMC over ACC.

Furthermore, this is only one of many ways accounting decisions can alter net income. Decisions on how to charge inventory (Last In First out, or First in First out), credit terms for product purchasers (accounts receivable), bill payment policy (accounts payable), and numerous other decisions affect when revenues and when costs are expensed, controlling what net income is presented to the public.

Finally, if we are focused on earnings only, and if the company has been hard at work "smoothing" out earnings wrinkles, we may miss large expenses, investments, or sales that should attract our attention. Careful reading of annual statements should bring all of these circumstances to our attention, but I find it's easier to absorb information when I'm looking for it rather than trying to absorb everything of importance out of a wordy document, when I don't know what to watch out for to start with.

Free Cash Flow

There is, of course, another way. Whether you are purchasing an investment property, or purchasing shares in a company, it is cash flow that ultimately drives your investment return. In the long run, cash flow (money in-money out) determines whether a company can pay its bills and creditors, and what it can distribute to its investors. A company can have negative cash flow for a time and not run aground. It will almost always claim negative cash flow is due to "investments." But unless those expenditures yield higher cash flows later, the company is doomed to failure, or at best mediocrity.

Given that it is cash flow that generates your profits, whether you are looking for capital appreciation, or dividend growth, it stands to reason that cash flow should form the core of our valuation metrics.

Free Cash flow, or money generated after cost of its operations and its spending on capital (investments in factories, machinery or equipment). In mathematical terms, its

EBIT (Earnings Before Interest and Taxes)+ Depreciation & Amortization)X(1-Tax Rate) - Change in Net Working Capital - Capital Expenditure

Free cashflow (NYSE:FCF) has some large advantages over the simpler net income per share. First, FCF does not include many of the adjustments that GAAP accounting allows for net income. Furthermore, FCF is not universally touted by analysts. Unlike earnings per share, it does not form the basis of performance measurements for most corporate managers. Consequently, free cash flow is not easily manipulated, and most managers don't have the motivation to do so.

In addition to giving us a more accurate depiction of profits, FCF also allows us something closer to an "apples to apples" view between companies. In our example above, ACME Coyote Catapult Co. had an EPS of $0.60 per share. But its free cash flow for that year was somewhat different.

EBIT ($80.00) +$50 X (1-25%) - $1000 = FCF of ($902.50)

AERO Marsupial Catapult Co. seems much more profitable at $0.675 of earnings a share. Both companies have identical costs and identical revenues. Run the proper calculations, and you will see that, unsurprisingly, both are generating the same amount of free cash.

EBIT ($90.00) +$40 X (1-25%)- $1000 = FCF of ($902.50)

It's hard enough to compare companies across industries, when companies in each industry require different debt levels, different investments in capital, and thousands of other aspects that make companies such as Bank of America (NYSE:BAC) almost unrecognizable when compared with Microsoft (NASDAQ:MSFT). How much worse do we make it on ourselves using a metric that can show such different results with essentially identical companies!

Free Cash Flow has its weaknesses as well. While most managers don't have the motivation to distort cash flow, it can be done. I welcome comments providing specific examples for discussion below.

In addition, the next logical step in using free cash flow to analyze a company's value is to conduct discount free cash flow analysis. Doing so requires some guesswork. We must estimate growth rates, we have to determine a discount rate, what a risk free rate is, how many years we should forecast out to and many other uncertainties. In the end, there is plenty of room for disagreements among analysts. But we control our inputs, and we have to justify each input with our own logic. We are left with a sense of what is driving the value in a stock, and that is important in the coming months and years as we hold a company that dips and climbs under the whims of the market.

Bottom Line

Having a baseline school of thought is important to investing. It gives us a starting point to judge value, and a baseline to compare others' strategies to ours. While we try to remain as objective as possible, we are bound to become resolute in our chosen methodology.

I firmly believe actual cash generated is the atom of any investment worth. Whether it's company stock, a rental unit, bonds, or an emu farm, the money it produces, and the growth prospects are what matters. It seems obvious when stated, so why rely on measurements subject to distortion that only tangentially reflect that cash. Earnings work for gamblers and the uninterested, but if you are serious about profiting from your investments, earnings alone aren't good enough for you.

Thank you for taking the time to read.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: P/E Is For Elementary School: Serious Investors Should Study Cash Flow