Your Cash Flow Matters More Than You Think

Every 90 days we experience the deja vu known as earnings season. The quarterly festival is promoted hard on sundry business cable outlets -- a logical, self-interested move on their part, given investor focus on the bottom line.

But every 90 days? It's more than a little silly, considering that quarterly financial statements are prepared using the integral method: According to Graham and Dodd's Security Analysis, the numbers are largely a reflection of management's estimates for full-year results. Their accuracy leans heavily on estimates of what future quarters will bring. Yet when a company misses earnings-per-share estimates by a penny or two, a precipitous price drop is not unusual.

Subjectivity rules
The fact is that where earnings -- in total or per share -- are concerned, estimates and subjectivity prevail. After all, earnings are affected by credit policies, financing choices, depreciation rates, reserve accounts, inventory accounting, write-offs, and discontinued segments. And those are only the variables that spring immediately to mind. If a company posted steady annual earnings growth over the past 10 years, only to post a massive write-off in year 11, were a decade of earnings a mere mirage?

Perhaps it's better to focus on cash flow; cash pays the bills. But cash flow is also open to interpretation, starting with cash flow analysis methodology. Less industrious investors rely on EBITDA as a cash flow proxy. EBITDA uses net income as a starting point and then adds back interest, taxes and the non-cash items depreciation and amortization. Problem is, a company could theoretically report positive cash flow even if it reports no revenue.  

Better to ground cash flow analysis in the direct method of calculating cash flows. Instead of starting with a reported net income, the direct method analyzes operating, financing, and investing activities and calculates cash flow created by converting all accrual accounts to cash figures, resulting in a much more insightful analysis compared to the indirect method.

From the overall cash flow analysis, investors will attempt to derive free cash flow -- cash left for the company's shareholders after the bills are paid and capital expenditures are made to keep the business humming.

Sounds straightforward enough, except when it isn't. Investors often disagree on which items should be treated as capital expenditures, if adequate capital expenditures are being maintained, and if working capital is being efficiently managed. Inadequate investment in capital equipment and in research and development produces high immediate cash flow, although the company is actually cannibalizing itself.

Real and tangible
No wonder I like dividends. Dividends reveal a lot about a company's health and management competency, sans the interpretive dance. It's much more difficult for rot to accumulate when a company is subjected to the rigors of paying a dividend. That's why I rely on dividends as a guide in gauging the veracity of financial statements.

I like growing dividends even better. They suggest veracity through time as well as a company that isn't taking shortcuts to goose cash flow or earnings by skimping on the investments necessary to maintain and grow earnings.

So, naturally I'm attracted to the following six companies, which have proven capable of backing the reported numbers with dividends. Moreover, the annual dividend increases suggest that management is managing capital expenditures and working capital not only to maintain earnings power but to increase it as well, while the payout ratios suggest the dividend isn't unduly stressful.

Nevertheless, I'm imperfect, and so are dividends as an indicator of future financial health. Two years ago, I probably would have included General Electric (NYSE:GE) and Pfizer (NYSE:PFE) in the list; therefore, dividend analysis isn't mutually exclusive from cash flow and earnings analysis. Over time, dividends, earnings, and cash flow should converge to similar growth rates. If not, something is amiss, so it's worth parsing the origins of cash flows and earnings.

That said, dividends go a long way toward tempering blue-sky financial reporting and its complement blue-sky investing, because dividends reflect reality. Besides, a dividend check comes in handy at times.