Cash is king. Despite what some business execs want you to believe, cash pays the bills -- accounting earnings do not. Cash flow is much more difficult to manipulate than earnings, which makes it a better analysis tool for investors. While reading The Smartest Guys in the Room, a detailed account of the Enron downfall, I was reminded yet again why cash flow -- and not earnings -- is so important.
Everybody loves Enron
One of the many, many problems at Enron was the way former president Jeff Skilling managed earnings. Skilling would ask Wall Street what earnings number he needed to produce to keep the share price high. Then he would try to hit that number.
Are you kidding me?
The president of a major corporation should tell Wall Street what earnings he expects after a careful analysis of the business, not the other way around. Enron had the process completely backward.
It gets worse. Often, Enron wasn't able to meet Wall Street's lofty expectations. Rather than admit defeat, management would do whatever it took to hit its numbers, including:
- Closing unfavorable deals so the profits could be booked before the end of the quarter.
- Using mark-to-market accounting excessively.
- Renegotiating or restructuring old deals to make them seem more profitable.
- Delaying losses on bad deals until the next quarter.
- Avoiding tax expenses through complicated financing arrangements.
None of these transactions are signs of a healthy, growing business. None of these involved cold, hard cash coming in the door. Enron's "profits" were merely paper profits, most of which hurt the company's long-term financials.
Brave new world
Times have changed since the Enron scandal. Today, we have increased corporate governance and Sarbanes-Oxley regulations. But earnings manipulation still happens.
In 2004, the SEC investigated blue chipper Coca-Cola (NYSE:KO) for "channel stuffing." Channel stuffing involves shipping inventory to its distribution channels ahead of schedule to inflate earnings, and it's one way to work around current accounting rules. Usually, distributors cannot sell this excess inventory and end up returning it. Acclaim Entertainment also allegedly stuffed the channels with its video games to boost revenue. Acclaim eventually filed for bankruptcy in 2004 and now trades on the pink sheets as a penny stock.
Even when management plays by the rules, accounting earnings are subject to change. Companies as diverse as ConAgra Foods (NYSE:CAG), Nortel Networks (NYSE:NT), Tyco (NYSE:TYC), General Motors (NYSE:GM), and Blockbuster (NYSE:BBI) have had to restate earnings recently, causing millions of dollars of profits to vanish.
Show me the money
Because of these earnings "discrepancies," investors should focus equally (if not more so) on the actual cash moving in and out of the business. Missing Wall Street estimates by a penny doesn't matter that much when the company is bringing in the green stuff each and every quarter.
Unfortunately, even free cash flow isn't completely immune from accounting vagaries, as my colleague (and indoor-soccer nemesis) Tim Hanson pointed out. That's why I like to see a long history of management distributing cash to shareholders through a dividend. A strong dividend policy ensures that management is committed to bringing in cash profits rather than paper profits. It ensures that real goods and services are being provided to real customers, rather than the complex (and misleading) financing arrangements of Enron.
Companies that have long histories of dividend payments are among the best performers historically. Just ask long-term shareholders of Johnson & Johnson (NYSE:JNJ), a business that has increased its dividend for the past 44 years. If you'd invested $1,000 in J&J back in 1980, you'd have more than $25,000 today with dividends reinvested.
The Foolish bottom line
Reading about Enron's flagrant abuse of the system shook my confidence in GAAP earnings, and I'm sure I'm not alone. It caused me to review my own investments to see if I'd been focusing too much on Wall Street's earnings game. I do have some small-cap growth holdings where the share price will be strongly tied to management's ability to beat estimates. Am I going to immediately dump these holdings? Of course not. But I will have to keep a closer eye on these investments than, say, on Johnson & Johnson.
Sure, I like it as much as the next guy when a company I own trounces Wall Street estimates. But I like it even better when I know those earnings are quality earnings.
If you're also getting tired of the earnings games managers play, take a free one-month visit to Motley Fool Income Investor. Lead analyst Mathew Emmert singles out quality, undervalued, dividend-paying stocks each month. These stocks are the cream of the crop: steady cash flow generators with market-beating potential. He also comes armed with an active community of like-minded investors willing to lend a helping hand. Learning about cash flow and dividend investing will help ensure that you don't fall victim to the next Enron. Click here to get started.
Joseph Khattab owns shares of Johnson & Johnson, which is an Income Investor recommendation. Coca-Cola and Tyco are Inside Value recommendations. The Fool has a strict disclosure policy.
