What Reynolds American Does With Its Cash

In the quest to find great investments, most investors focus on earnings to gauge a company's financial strength. This is a good start, but earnings can be misleading and incomplete. To get a clearer understanding of a company's ability to earn money and reward you, the shareholder, it's often better to focus on cash flow. In this series, we tear apart a company's cash flow statement to see how much money is truly being earned and, more importantly, what management is doing with that cash.

Step on up, Reynolds American (NYSE: RAI).

The first step in analyzing cash flow is to look at net income. Reynolds American's net income over the last five years has been impressive:

Source: S&P Capital IQ.

Next, we add back in a few non-cash expenses, like the depreciation of assets, and adjust net income for changes in inventory, accounts receivable, and accounts payable -- changes in cash levels that reflect a company either paying its bills or being paid by customers. This yields a figure called "cash from operating activities" -- the amount of cash a company generates from doing everyday business.

From there, we subtract capital expenditures, or the amount a company spends acquiring or fixing physical assets. This yields one version of a figure called "free cash flow," or the true amount of cash a company has left over for its investors after doing business:

Source: S&P Capital IQ.

Now we know how much cash Reynolds American is really pulling in each year. Next question: What is it doing with that cash?

There are two ways a company can use free cash flow to directly reward shareholders: dividends and share repurchases. Cash not returned to shareholders can be stashed in the bank, invested in other companies, or used to pay off debt.

Here's how much Reynolds American has returned to shareholders in recent years:

Source: S&P Capital IQ.

As you can see, the company has repurchased a decent amount of its own stock. That's caused shares outstanding to fall:

Source: S&P Capital IQ.

Now, companies tend to be fairly poor at repurchasing their own shares, buying feverishly when shares are expensive and backing away when they're cheap. Does Reynolds American fall into this trap? Let's take a look:

Source: S&P Capital IQ.

Reynolds' buybacks over the last five years have been sporadic -- its main way of rewarding shareholders is through dividends. But what buyback behavior we have to analyze isn't remarkable. The company's largest buyback over the last five years came just recently, after shares more than doubled from their recession low. With shares at historically pricey valuations, that's not the kind of value-seeking behavior shareholders should be impressed with.

Finally, I like to look at how dividends have added to total shareholder returns:

Source: S&P Capital IQ.

Shares returned 92% over the last five years, which drops to 37% without dividends -- a nice boost to top off already high performance.

To gauge how well a company is doing, keep an eye on the cash. How much a company earns is not as important as how much cash is actually coming in the door, and how much cash is coming in the door isn't as important as what management actually does with that cash. Remember, you, the shareholder, own the company. Are you happy with the way management has used Reynolds American's cash? Sound off in the comment section below.

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