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Understanding EPS And Operating Cash Flow To Make Smarter Stock Buys

|Includes:Apollo Global Management, LLC (APO), GLW, GOOG, MSFT

Picking stocks can be like picking a winning horse when you know nothing about horse racing. You read the odds but have no idea how they got there and if some horses' odds are too high or too low. And how often have the favored horses won versus the underdogs [or is it underhorse]?

Microsoft FundamentalsReading fundamentals can be like reading a foreign language. Actually, it is - the language of investing your future in a bunch of numbers that make no sense.

So, I'm dedicating myself to understanding what these numbers mean. I've read in some places that reading fundamentals isn't the best way to make purchases. Understood, but I can't see how it'll hurt. Doing a technical analysis on a stock's movement makes even less sense to me, but I'll be getting around to that as well.

For now, though, I'm going to pick a topic and do what I can to understand it. And since I know a lot of people who are interested in investing but are terrified of this foreign language, maybe I can help make some sense of all these abbreviations.

Let's start with earnings per share also known as EPS. In a couple of sentences, Investopedia defines it as the following:

The portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability.

And if you're scratching your head because you don't know what an outstanding share is, well, I did to.

Stock currently held by investors, including restricted shares owned by the company's officers and insiders, as well as those held by the public. Shares that have been repurchased by the company are not considered outstanding stock.

So, EPS is how much of the profit a company allocates to each share owned by someone be it the company's CEO or you and me. The higher the EPS, the more attractive a stock should look. But it can't possibly be that simple, right? Looking at the most bought stock from the gurus of investing, Microsoft Corporation (MSFT) has an EPS of 1.94; meanwhile, Google (GOOG) has an EPS of 33.42. What gives?

Well, to take a more thorough answer and sum it up for those in a rush to get to analyzing, you compare the EPS to the operating cash flow per share. Operating cash flow per sharedefined by Investopedia is:

Cash flow per share shows the after-tax earnings plus depreciation, on a per share basis. Many financial analysts place more emphasis on the cash flow per share value than on earnings per share values. While an earnings per share value can be easily manipulated to appear more positive than it really is, therefore putting its reliability in question, cash is more difficult to alter, resulting in what some analysts believe is a more accurate value of the strength and sustainability of a particular business model.

Essentially you compare what a company is reporting as profit allocated per share or EPS versus how much operating cash flow they have for each of those shares. A high EPS looks attractive, but if the company has low or no or negative operating cash flow per share, that's a bad sign. They could be taking out loans faster than they can pay them back which will only last but for so long.

Let's take a look at two stocks on my watch list: Corning, Inc. (GLW) and Apollo Global Mgmt LLC (APO). Corning has an EPS of $1.30 while Apollo Global has an EPS of $3.71. At first glance, it's a no-brainer. But looking at each company's operating cash flow per share, well, let's think about it. Corning's operating cash flow is $2.38 per share; Apollo Global's operating cash flow is -$2.40. Yes, that's a negative.

So from my elementary understanding of EPS and operating cash flow, Apollo Global is allocating more of its profit per share owned by the people, but it's not generating the operating cash flow to run the company without relying on lines of credit, loans or whatever companies like this do. Meanwhile, though Corning isn't allocating as much of its profits per share, it has the operating cash flow to run its business without the worry of someone cashing in on an IOU.

But before someone from Apollo Global calls me to better clarify why their operating cash flow is low, which I'd welcome them to do (or call me to sue so I won't be posting my number), there may be valid reasons why companies have a negative operating cash flow that is normal, acceptable, common or even necessary. Beats me.

Until I get a better understanding of it, though, I'm going to error on the side of caution. Let's see, Microsoft's operating cash flow per share is $3.02; Google has an operating cash flow per share of $35.78. Could it be because Microsoft has almost 57% more employees, any company's highest operating expense? Or for each dollar Google makes from AdSense, it spent virtually nothing? Maybe that explains Google's stock price being more than $800 more per share than Microsoft's.

When I looked at my current portfolio, three of the stocks I own have operating cash flow of less than $1.00. Going to have to do something about that. And as I vet my watchlist, I'll be taking a closer to look to the EPS and operating cash flow, now that I know a little something, before making future purchases.