When I look for prospective investments, one of the key things I look for is a company's operating cash flow. I do this for two reasons. First, operating cash flow is harder to manipulate and gives a truer picture of an expanding business than EPS. In addition, the growth in operating cash flow should roughly equal the growth of EPS over time. In a perfect world, the EPS and CF should be moving up together with a strong correlation. If there is divergence between the two, it can be a significant red flag.
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The best way to demonstrate this type of analysis is to look at two well known companies at opposite ends of the spectrum. On the suspicious side, I would like to highlight Netflix (NFLX). As you can see from the chart above, NFLX's cash flow has not followed the trajectory of its earnings. Since 2006, Netflix's cash flow has increased approximately 25% overall. Contrast this to its earnings growth which has seen an increase of over 400%. Given the increasing competition from Google (GOOG), Amazon (AMZN), and HBO among others; the prospect of raising subscription prices are pretty slim. On the cost side, the increasing demand for content will lead to an escalating price war for premium programming. Given this, it is hard to see much relief for NFLX's cash flow in the short or medium term. At over 55 times projected 2011 earnings, NFLX is pricey at best. Given its challenges in growing cash flow, I have a strong sell on this equity. AVOID
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A stock that demonstrates how a company's cash flow and EPS should go up in tandem is Apple. Apple's cash flow has moved in lockstep with its earnings over the five years. This correlation gives me a very good confirmation that Apple's earnings are verifiable and are feeding directly from its ability to generate cash flow. At less than 14 times 2011's consensus earnings and with $31/share in net cash, Apple is selling at a very low valuation despite its rapid growth. STRONG BUY
Pair Trade: For more aggressive investors, a paired position of being long Apple and short Netflix might be appropriate.