Why National Oilwell Varco's Earnings Aren't So Hot

Although business headlines still tout earnings numbers, many investors have moved past net earnings as a measure of a company's economic output. That's because earnings are very often less trustworthy than cash flow, since earnings are more open to manipulation based on dubious judgment calls.

Earnings' unreliability is one of the reasons Foolish investors often flip straight past the income statement to check the cash flow statement. In general, by taking a close look at the cash moving in and out of the business, you can better understand whether the last batch of earnings brought money into the company, or merely disguised a cash gusher with a pretty headline.

Calling all cash flows
When you are trying to buy the market's best stocks, it's worth checking up on your companies' free cash flow (FCF) once a quarter or so, to see whether it bears any relationship to the net income in the headlines. That brings us to National Oilwell Varco (NYSE: NOV  ) , whose recent revenue and earnings are plotted below.

Source: Capital IQ, a division of Standard & Poor's. Data is current as of last fully reported fiscal quarter. Dollar values in millions. FCF = free cash flow. FY = fiscal year. TTM = trailing 12 months.

Over the past 12 months, National Oilwell Varco generated $657 million cash on net income of $1,621 million. That means it turned 5.4% of its revenue into FCF. That sounds OK. Still, it always pays to compare that figure to sector and industry peers and competitors, to see how your company stacks up.

Company

TTM Revenue

TTM FCF

TTM FCF Margin

 National Oilwell Varco $12,118 $657 5.4%
 Schlumberger (NYSE: SLB  ) $24,123 $2,435 10.1%
 Weatherford International (NYSE: WFT  ) $9,737 $60 0.6%
 McDermott International (NYSE: MDR  ) $5,532 $73 1.3%

Source: Capital IQ, a division of Standard & Poor's. Data is current as of last fully reported fiscal quarter. Dollar values in millions. FCF = free cash flow. TTM = trailing 12 months.

All cash is not equal
Unfortunately, the cash flow statement isn't immune from nonsense, either. That's why it pays to take a close look at the components of cash flow from operations, to make sure that the cash comes from high-quality sources. They need to be real and replicable in the upcoming quarters, rather than being offset by continual cash outflows that don't appear on the income statement (such as major capital expenditures).

For instance, cash flow based on cash net income and adjustments for non-cash income-statement expenses (like depreciation) is generally favorable. An increase in cash flow based on stiffing your suppliers (by increasing accounts payable) or shortchanging Uncle Sam on taxes will come back to bite investors later. The same goes for decreasing accounts receivable; this is good to see, but it's ordinary in recessionary times, and you can only increase collections so much.

So how does the cash flow at National Oilwell Varco look? Take a peek at the chart below, which flags questionable cash flow sources with a red bar.

Source: Capital IQ, a division of Standard & Poor's. Data is current as of last fully reported fiscal quarter. Dollar values in millions. TTM = trailing 12 months.

When I say "questionable cash flow sources," I mean items such as changes in taxes payable, tax benefits from stock options, and asset sales, among others. That's not to say that companies booking these as sources of cash flow are weak, or are engaging in any sort of wrongdoing, or that everything that comes up questionable in my graph is automatically bad news. But whenever a company is getting more than, say, 10% of its cash from operations from these dubious sources, investors ought to make sure to refer to the filings and dig in.

With questionable cash flows amounting to only 4.1% of operating cash flow, National Oilwell Varco's cash flows look clean. Within the questionable cash flow figure plotted in the TTM period above, stock-based compensation and related tax benefits provided the biggest boost, at 7.8% of cash flow from operations. Overall, the biggest drag on FCF came from changes in accounts receivable, which consumed 39.7% of cash from operations.

A Foolish final thought
Most investors don't keep tabs on their companies' cash flow. I think that's a mistake. If you take the time to read past the headlines and crack a filing now and then, you're in a much better position to spot potential trouble early. Better yet, you'll improve your odds of finding the underappreciated home-run stocks that provide the market's best returns.

We can help you keep tabs on your companies with My Watchlist, our free, personalized stock tracking service.

Seth Jayson owns no shares of the companies mentioned. You can view his stock holdings here. He is co-advisor of Motley Fool Hidden Gems, which provides new small-cap ideas every month, backed by a real-money portfolio. National Oilwell Varco is a Motley Fool Stock Advisor pick. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 05, 2010, at 11:58 AM, Estiv wrote:

    Seth, this is a great article!

    I'm ran my spread sheet out and the quarterly shows improved Quality of Earnings (137%), Current Ration at 2.67 and free cash flow for Mar, June and Sept at 64, 204 and 595 respectively.

    Now, comes the tricky part Share Value:

    Using 12% annual growth, Avg Yrly FCF = $1,644 when taken out 14 years to 2024.

    Discounted Cash Flow (using a discount rate of .982), 14 years is $16,277,000,000.

    Divided by Diluted Weighted Shares Outstanding

    approximates today's share value of 63.13.

    Taking the discount rate up to 1.05% and the share value drops to $38.85 !

    Now, what discount rate are you using these days to calculate DCF?

    Is 0.982% reasonable give savings accounts are receiving 0.05%?

    Again, awesome article.

    I can share my spread sheet which only requires cutting and pasting income, balance and cash flow from

    http://www.motleyfool.idmanagedsolutions.com/stocks/income_s...

    if you tell me how or where to post it.

    Cheers

  • Report this Comment On December 05, 2010, at 2:37 PM, Estiv wrote:

    Corrected DCF formula. New DCF formula uses an increasing FCF based on 12% growth estimate.

    Growth Source:

    http://finance.yahoo.com/q/ae?s=nov+Analyst+Estimates

    "Next 5 yrs" growth rate reduced by 20% (times 0.8).

    Previous post using the AVERAGE FCF over 14 year period.....

    DCF Excel Formula:

    .

    .

    FCF = Range("S15")

    DCF = 0

    For i = 1 To Range("AB29")

    DCF = DCF + FCF / (iDiscountRate ^ i)

    FCF = FCF * (1 + Range("$X19"))

    Next i

    Now, with the 12% growth rate applied to FCF in the FOR LOOP, a discount rate of 1.085% approximates the current share price ($63.82/share) starting with the Sept'10 FCF of 595.

    What is the discount rate to use in this case to calculate DCF? Anyone?

    Took the update for DCF from:

    http://www.investopedia.com/articles/07/DCF_pitfalls.asp

    They refer to another rate called WACC which I'm not close to tackling!

    http://www.investopedia.com/articles/fundamental/03/061103.a...

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