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An article I wrote in July 2013 ("4 Opportunities Using Dividend Growth Rate And Yield On Cost") analyzed several different scenarios of initial dividend yields and dividend growth rates, providing investors in conclusion with several real life, present day investment opportunities that exceeded the yield and growth scenarios I modeled. A number of commentators posited that dividends were dependent upon corporate earnings, while I advocated it is cash flow, not earnings, that may matter most. As a result, I committed to writing this article to further the discussion of the importance of earnings and cash flow to income investors.

This article defines keys terms relevant to this discussion, provides examples of how the key terms are applied in GAAP accounting and presents several historical market return scenarios of dividend paying stocks using the key terms as the criteria for selecting investments.

OUTLINE

1) Defining "earnings" and "cash flow"

2) Cash cycle examples: accrual accounting vs. cash flow

3) Historical market returns using earnings and cash flow

4) Conclusion

1) DEFINING "EARNINGS" AND "CASH FLOW"

EARNINGS:

Earnings, or Net Income, can be found toward the bottom of an Income Statement. Earnings roughly represent the difference between the sales of a company and its expenses. Obviously the specifics of accounting are much more complex, but underneath all the complexity the idea being communicated is:

Earnings (net income) = sales - expenses

CASH FLOW:

Cash Flow can be thought of in several ways but for purposes of our discussion shall be defined generally as the difference between cash received and cash spent. Some investors and analysts even consider EBITDA to represent cash flow, but this is largely inaccurate because EBITDA does not take into account the changes in working capital. Cash flow predominantly consists of cash activity resulting from: operations, investing and financing. For purposes of our discussion, income oriented investors should consider cash flow to be defined as:

Cash flow (free cash flow) = cash from operations - capital expenditures

Using free cash flow allows investors to determine the cash left over from operations after paying for expenses related to maintaining and improving the company's operations. Free cash flow provides income investors with a metric to determine the health of the relationship between the cash required to make dividend payments and the cash available to make such dividend payments from the company's normal operations.

2) CASH CYCLE: ACCRUAL ACCOUNTING VS. CASH FLOW

REVENUE:

GAAP enable companies to legitimately record sales in the period in which they occur regardless of when the company actually receives funds resulting from such sales.

On May 30, 2013, Nike paid a dividend of $0.21 per share, or approximately a total of $188 million in dividends. Let us assume Nike (NKE) sold $300 million worth of merchandise to local retailers on May 10, 2013. Does this mean Nike received $300 million in cash on May 10? No; customers typically have 30 to 90 days before they must transfer cash to their suppliers. This is called Accrual Accounting. Further, let us assume Nike had expenses of $50 million to acquire the raw materials and manufacture the merchandise.

Using our definition of Earnings above, Nike has "earned" $250 million ($300 - $50 = $250).

Could Nike have paid this dividend using the Earnings of $250 million from our example above? Emphatically no! Remember that Nike's customers will not have transferred any cash to them until at least June 9th, if not later, which is certainly after May 30th.

There are two important points to take away:

1) Nike must use cash in the bank, issue new equity or take on additional debt in order to come up with the cash to actually pay the dividend(s); and

2) Companies can intentionally book large volumes of sales in a given period to artificially inflate earnings, whilst receiving no actual cash to conduct normal business or return to shareholders

CAPITAL EXPENDITURES:

Another important factor of a company's cash cycle to discuss is the capitalization of equipment purchases. GAAP allow for companies, at their own discretion, to determine expected lifetime of capital expenditures. This sole discretion, and resulting variability in depreciation and amortization, enables a company to easily influence their Earnings.

Leggett & Platt, Incorporated (LEG) reported capital expenditures of nearly $20 million on their June 30, 2013 quarterly report. It is irrelevant whether Leggett used cash already on hand, or took on additional debt (subsequently increasing cash "on hand"), to purchase these capital goods.

What IS relevant is the lifetime Leggett attributed to these purchases for depreciation purposes.

For example, Leggett could choose to decide for accounting purposes that the equipment they purchased has a usable life of only one period and thus reduce their Earnings in the same period by expensing the full $20 million. Alternatively, Leggett could make the decision to claim the equipment has a useful life of ten periods, expensing only one-tenth, or $2 million, in the present period.

The result on Earnings of this discretionary expensing decision is dramatic:

Let us assume Leggett had $10 million of Sales and their only Expense was depreciation. This provides for two alternative conclusions using our example:

Leggett could report Earnings of either $8 million or $(10) million.

But remember, Leggett still needed to come up with $20 million to purchase this capital equipment.

3) HISTORICAL MARKET RETURNS USING EARNINGS AND CASH FLOW

The results provided in the following tables assume several given assumptions:

1) All stocks analyzed were listed on a major U.S. stock exchange and were required to have a Dividend Yield of at least 1%;

2) Returns are capital gains ONLY and do not include any reinvested dividends or transaction costs;

3) Returns for any given year were calculated by subtracting the price per share of each stock on January 1 from the price per share on December 31 for all stocks meeting the specified criteria on January 1 of the given year; and

4) The numbers presented below are percentages, except for Year and Count, the latter of which is the actual number of companies meeting the specified criteria on January 1, 2011. For example, the 1447 companies with positive Earnings in 2011 cumulatively returned a 2.35% capital loss.

I must admit I am quite surprised by the results of my research. Please remember the stocks analyzed were required to have a minimum 1% dividend yield, which narrows the universe in any given year from approximately 5,000 possible stocks to approximately 1,500.

Below are four tables:

1) Positive earnings and cash flow;

2) Negative earnings and cash flow;

3) Payout ratios less than 25%; and

4) Positive earnings and cash flow and price to each less than 5.

TABLE 1. POSITIVE EARNINGS AND CASH FLOW

Count

1447

1323

Year

Positive Earnings

Positive Free Cash Flow

2002

4.57

4.89

2003

35.21

35.71

2004

16.23

15.93

2005

5.51

4.78

2006

14.43

14.28

2007

(3.16)

(4.43)

2008

(32.75)

(32.00)

2009

25.10

26.56

2010

17.53

18.26

2011

(2.35)

(2.26)

Total

86.00

88.00

CAGR

7.14

7.27

Nothing particularly conclusive jumps out of Table 1 when we require either positive Earnings or Free Cash Flow. Both alternatives had a total return of over 85%, or more than 7% compounding annually. However, this requirement is too broad as more 75% of all companies paying a dividend of at least 1% in each year had both positive Earnings and Free Cash Flow.

Winner: Tie

TABLE 2. NEGATIVE EARNINGS AND CASH FLOW

Count

175

282

Year

Negative Earnings

Negative Free Cash Flow

2002

(14.65)

7.95

2003

49.53

39.08

2004

22.61

12.92

2005

(7.78)

5.13

2006

26.66

18.53

2007

(18.29)

(1.29)

2008

(53.99)

(45.40)

2009

50.63

47.22

2010

18.75

14.95

2011

(13.12)

(9.25)

Total

7.00

75.00

CAGR

0.75

6.42

Interestingly enough nearly twice as many companies had negative Free Cash Flow in 2011 as those who had negative Earnings, 282 and 175 respectively. Unlike Table 1 above, Table 2 clearly separates these two metrics apart. Companies with negative Earnings only managed to return a total of 7% over the decade analyzed, whereas companies with negative Free Cash Flow returned ten times that, or a total return of 75%.

Winner: Free Cash Flow

TABLE 3. PAYOUT RATIOS LESS THAN 25%

Count

505

715

Year

Earnings Payout Ratio less than 25%

Free Cash Flow Payout Ratio less than 25%

2002

4.76

5.31

2003

45.99

41.15

2004

24.54

18.49

2005

11.64

10.21

2006

22.39

18.68

2007

2.42

2.61

2008

(38.13)

(37.57)

2009

46.47

42.41

2010

21.24

19.38

2011

(5.49)

(4.49)

Total

177.00

140.00

CAGR

11.99

10.22

Many income investors including myself use a range of metrics and ratios when analyzing potential investments, not just positive or negative total Earnings or Free Cash Flow. In Table 3 I required companies with a dividend of at least 1% to also have an Earnings or Free Cash Flow payout ratio below 25%. This is well below the 50% to 75% range than many investors permit. For sake of simplicity I chose a lower payout ratio because it resulted in fewer companies qualifying and higher CAGRs in both scenarios.

In Table 3 we find that using Payout Ratios of less than 25% instead of overall Earnings or Free Cash Flow provides us nearly double the overall total return and a greater than 10% compounded annual return in each case.

Winner: Earnings

TABLE 4. POSITIVE EARNINGS AND CASH FLOW AND PRICE TO EACH LESS THAN 5

Count

41

166

Year

Positive Earnings and Price to Earnings less than 5

Positive Free Cash Flow and Price to Free Cash Flow less than 5

2002

14.69

12.27

2003

54.04

42.25

2004

33.20

15.98

2005

23.75

20.20

2006

29.92

23.60

2007

30.90

23.77

2008

(36.75)

(35.52)

2009

73.78

55.26

2010

32.12

27.59

2011

2.70

(2.87)

Total

639.00

323.00

CAGR

24.89

17.38

Table 4 is where things start to get interesting. In Table 4 I maintained the 1% dividend yield requirement and added the restrictions of having positive Earnings or Free Cash Flow and a Price-to-each-respective-metric of less than 5. Many investors view stocks with a P/E ratio of 8 to be considered left of dead, and stock with P/E ratios between 12 and 20 to generally be fairly valued. However, for purposes of this analysis I chose 5 to be the threshold.

Neither strategy could escape the drama that began to unfold in 2008, both recording losses in excess of 35%. Fascinatingly enough, with the except of one year (2011), both strategies managed to generate a positive return every single year analyzed, which ultimately producing tremendous returns over the years.

The Earnings strategy compounded annually nearly 25%, for a total return in excess of 600%. While respectable on its own, the Free Cash Flow strategy only managed to compound annually approximately 17.5%.

Winner: Earnings

4) CONCLUSION

With one Tie and two Wins earned by Earnings, the specific data and time periods analyzed indicate Earnings can be used by investors more successfully than Free Cash Flow to achieve higher market returns. Further, the only strategy with a manageable (for individual investors) number of total companies was the Earnings strategy from Table 4, which just so happens to have been by far the best performing strategy.

Feel free to make use of the comment section below if you are interested in discussing my selected scenarios, methodology or learning more about the tools I used to perform this analysis.

Source: Roadmap To Higher Returns: Earnings Vs. Cash Flow