Although business headlines still tout earnings numbers, many investors have moved past net earnings as a measurement 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're 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 Red Hat (NYSE: RHT ) , whose recent revenue and earnings follow.
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, Red Hat generated $226.1 million cash on net income of $87.5 million. That means it turned 27.6% of its revenue into FCF. Sounds pretty impressive, but it always pays to compare that figure with those from sector and industry peers and competitors, to see how your company stacks up.
TTM FCF Margin
|Microsoft (Nasdaq: MSFT )||$62,484||$22,096||35.4%|
|Oracle (Nasdaq: ORCL )||$29,268||$8,467||28.9%|
|Symantec (Nasdaq: SYMC )||$5,986||$1,411||23.6%|
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 the cash comes from high-quality sources. These numbers 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 on shortchanging Uncle Sam on taxes will come back to bite investors later. The same goes for decreasing accounts receivable: This is a good thing to see, but it's ordinary in recessionary times, and you can only increase collections so much.
So how does the cash flow at Red Hat look? Take a peek at the following chart, 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 17.4% of Red Hat's operating cash flow coming from questionable sources, investors should take a closer look at the underlying numbers. Within the questionable cash-flow figure plotted in the TTM period above, other operating activities -- which can include deferred income taxes, pension charges, and other one-off items -- provided the biggest boost, at 14.9% of cash flow from operations. Overall, the biggest drag on FCF came from capital expenditures, which consumed 12.0% 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.
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