Cash Isn't a Cruel Measure

A couple of weeks ago, I talked about the importance of return on equity (ROE) to the Hidden Gems investing philosophy. It's a powerful metric because it's simple to calculate and helps us to understand how well a company's management allocates capital.

And although it's simple on the surface, investors can use ROE to dive into more complex elements of a business to see how effectively management pulls different levers involving pricing, assets, and debt. (Bill Mann eloquently explained these concepts last month.)

Every time I look at the formula for ROE, however, I get the urge to tinker with it. As you'll recall:

ROE = net income / avg. shareholders' equity

What has always nagged at me is the use of net income in the numerator. You'll find many articles written here at Fool.com talking about the superiority of free cash flow over net income. The reason is that accrual-based net profit can be manipulated in a number of ways, but it's hard to fake the actual amount of real cash flowing into and out of a business.

So, then, why not use free cash flow in the numerator of the ROE equation? This is not exactly a groundbreaking idea; we already use price-to-free cash flow to complement the P/E ratio, and the Cash King Margin as a proxy for net margin.

Apparently I'm not the only one thinking along these lines, because I received a few emails after my last column asking me that same question. In addition, I'm currently reading through the wonderfully detailed The Analysis and Use of Financial Statements. The section on ROE says that while such profitability ratios are traditionally calculated using accrual-based income measures (i.e., net income), there's nothing wrong with giving them a whirl with cash flow substitutes.

What other substitutes are there other than free cash flow? Well, a metric already exists that is sometimes referred to as free cash flow to equity (FCFE). That is measured as net income - (capital expenditures - depreciation) - changes in working capital + net borrowings. This number theoretically represents cash flows available to equity investors -- money that could be returned as dividends or used to buy back shares. We could put that in the numerator over average shareholders' equity to come up with an ROE-type percentage.

Alternatively, Tom Gardner frequently substitutes structural free cash flow (SFCF) for net income when digging for potential hidden gems. (And he must be doing something right, garnering a total average return of 55% over the past year.) SFCF is very similar to FCFE.

So, what the heck... let's run some numbers and then try to figure out what they're telling us. We'll use traditional free cash flow in the numerator; let's call it CROE for cash ROE. The table below compares CROE to plain ol' ROE for several companies going back the last four fiscal years.

It's good to look at ROE as a trend, and it's also useful to compare companies within an industry. The table provides a variety of comparisons. While Anheuser-Busch has usually had a lower CROE than ROE over the past four years, both measures have improved dramatically. Microsoft's ROE fares better when cash flow is used, but its overall trend is slightly downward.

The next three pairs are competitors. The larger companies have more established numbers, while the small caps are all over the place and harder to interpret. The most interesting one is Enodis, a manufacturer of equipment for food service companies. Its traditional ROE line looks awful, sitting deep in negative territory for the last three years. Yet the cash-based ROE is much better, well on the positive side. The difference is because this London company reported negative U.S. GAAP net income during that period, primarily because of non-cash goodwill impairment charges. But these items had no effect on cash, and Enodis has reported positive free cash flow during this time.

While all this is fun to tinker around with, I'm not going to be tossing out the traditional ROE calculation. No metric is perfect, and accrual measures should be used in conjunction with cash methods to come up with a more complete picture of a company's business. I'm fortunate enough to have a good stock-screening program that allows me to set up my own formulas, and I've included CROE and other cash-based ROE metrics for comparison purposes -- so perhaps we'll return to the topic in future Hidden Gems columns.

There's a Hidden Gems price increase coming, but you can lock in the charter rate now. Find out more.

Rex Moore prefers cash-based paychecks, and owns shares of Microsoft and Anheuser-Busch. His profile is here, and the Fool's disclosure policy is there.