Stock market losses hurt, which is why more smart investors are taking a closer look at a company's free cash flow. In the wake of creative-accounting scandals at Enron and Global Crossing at the beginning of the century, and more recently, with restatements at Tommy Hilfiger (NYSE:TOM), RedHat (NASDAQ:RHAT), and now-bankrupt Delphi, individual investors are trusting 10-K numbers less and less. We're skeptical of earnings and want to see them backed up by cash in the bank.
That healthy dose of skepticism has taken many investors beyond the income statement to the very helpful statement of cash flows. By subtracting capital expenditures from cash from operations, investors can calculate free cash flow -- the amount of money a company actually took in during the given time period. When valuing an equity, this number is often more helpful than net income since it is harder for companies to augment. Cash is cash is cash, right?
Still one step behind
Yet companies today know that more investors are looking for cash, and many have responded in kind. A recent study by the independent Georgia Tech Financial Analysis Lab showed just how some of the market's largest companies have succeeded in making their cash flow appear more attractive. It summarized the issue perfectly when it wrote that "a temporary reduction in capital expenditures could cause free cash flow to increase in an unsustainable way."
If you're playing along at home, you see the rub here: There are ways to play with capital expenditures data and increase cash flow in a way that does not represent the underlying business. Consider that the Georgia Tech study found that operating cash flow reported by non-financial firms in the S&P 100 rose nearly 14% from 2000 to 2003. That's great for investors who are rightfully chasing cash, but it's also good reason to be suspicious.
And suspicion would serve you well in this case. According to the Georgia Tech data, a number of companies "enjoyed a temporary boost to adjusted free cash flow through reductions in capital expenditures." In other words, the cash gains were generally unsustainable. These included Honeywell (NYSE:HON), Intel (NASDAQ:INTC), and Lucent (NYSE:LU).
Lucent saw capital expenditures decrease 77% from 2000 to 2002 -- from $1.9 billion to $449 million -- resulting in a nearly 50% adjusted free cash flow gain over the same time period (although cash flow stayed negative). In the year's 10-K, Lucent doesn't break out the reasons for the drastic reduction, but it's probably safe to assume that it was due to a combination of factors, particularly if the company was (smartly) reeling in spending after the tech bubble burst. But the substantial decline is questionable and makes it nearly impossible to value the company with any certainty.
Lucent finally turned free cash flow-positive in 2004 and remained so over the past year, although capital expenditures are starting to creep back up, and the company may or may not continue to bank cash.
Then there's the outsized depreciation/amortization number that made its cash number appear a bit better in 2001, albeit still ugly. What was a $1.7 billion charge in 2000 became a $2.5 billion charge in 2001 and came back down to $1.5 billion in 2002. That depreciation is in line with the greater capital expenditures in the previous year (which means there aren't any accounting shenanigans going on here), but inconsistent writedowns are generally more art than science -- making a cash-based valuation that much more difficult.
The lesson here is that it pays to scrutinize every assumption made when looking at revenue, income, and cash flow. You can do so by reading the financial footnotes and trying to find explanations for numbers that don't seem to fit any discernible trend and then adjusting for that in your own calculations. In cases where there is so much going on that it's impossible to draw any conclusions about cash, it is best to move on. (I've never even contemplated investing in Lucent.)
A cash-back king
This is a particularly important lesson for income investors, since it is out of free cash flow that companies fund dividends. The Georgia Tech study highlights Coca-Cola (NYSE:KO) as "one of the more stable companies in the study." The reason for this is that free cash flow grew in step with operating cash flow, and capital expenditures increased at 5.4% -- in line with the company's past reporting.
There's stability in this growing cash stream, and it's no wonder that Coke has raised its dividend for 43 consecutive years. Even better, dividend investors can feel confident stashing their money in this venerable company because of its stable and comparatively easy-to-understand financial statements.
Dividend and conquer
Coca-Cola -- with its rising dividend, regular cash flow growth, and shareholder-focused management -- is exactly the type of company that Fool analyst Mathew Emmert recommends for his Motley Fool Income Investor subscribers (although he tends to go with yields greater than Coke's 2.6%). By identifying companies such as Heinz (NYSE:HNZ) and more than 50 others that he believes can generate enough cash year after year after year to fund capital expenditures and reward shareholders with a growing dividend, Mathew has helped subscribers beat the market by three percentage points since his newsletter's inception two years ago. This isn't surprising when you consider that dividends account for nearly half of the market's 10.6% annualized return since 1926. Moreover, his readers have reaped these gains while experiencing less volatility than the broader market (a fact of which I know Mathew is particularly proud) and partly without having to sell any stock.
To join Mathew in his hunt for rewarding and reliable cash flow statements, click here to take a 30-day free trial. There is no obligation to subscribe.
Coca-Cola is a Motley Fool Inside Value recommendation. Tim Hanson does not own shares of any companies mentioned. At the Fool, no writer is too cool for disclosure . and Tim's pretty darn cool.
