Every three months, investors and Wall Street analysts alike wait with bated breath for companies to announce their quarterly results. Most headlines focus only on a company's earnings, and whether those earnings beat the consensus estimates among analysts. Yet by looking at other ways to gauge a company's performance, you can get a totally different perspective -- even if that means digging a little bit deeper into the quarterly financials.
Going past earnings
It makes sense that so many people focus first and foremost on a company's net income. Proven profitablity is one of the key ways a business demonstrates its success. Eventually, any business that can't generate net income will fail, either because it no longer attracts new investors, or because it collapses under the weight of its own debt.
Unfortunately, net income is not as simple as it looks. Generally accepted accounting principles that govern how companies report net income can lead to some strange distortions, which can mislead novice investors into drawing the wrong conclusions. In some cases, companies can take actions that are specifically designed to affect reported net income in a way that may mask concerns -- ones that shareholders would want to follow closely.
By contrast, another measure, free cash flow -- defined as a company's cash generated from operations, less what it spends for capital expenditures -- is less vulnerable to artificial manipulation. Looking at how free cash flow compares to net income can tell you a lot about what's going on with a company.
Big differences?
In some cases, looking at the two figures yields vastly different results. For instance, here are the five companies for which net income was staggeringly higher than free cash flow:
|
Stock |
Net Income (Loss) |
Free Cash Flow |
|---|---|---|
|
Citigroup (NYSE: C) |
($1.6 billion) |
($56.9 billion) |
|
Morgan Stanley (NYSE: MS) |
$1.3 billion |
($46.0 billion) |
|
Sallie Mae |
$324 million |
($15.9 billion) |
|
ExxonMobil (NYSE: XOM) |
$19.3 billion |
$5.9 billion |
|
Merck (NYSE: MRK) |
$12.9 billion |
$1.9 billion |
Source: Capital IQ, a division of Standard and Poor's. Figures are for trailing 12 months.
The disparities can come from a variety of places. Both Citi and Morgan Stanley see dramatic swings in their working capital from year to year, with trading accounts, federal funds transactions, and brokerage payables and receivables all potentially affecting cash flow. Given the accounting shenanigans recently revealed at some banks, investors are right to look more deeply for explanations. For Merck, the primary difference comes from gains that the company recognized in connection with its takeover of Schering-Plough.
Yet you shouldn't automatically consider discrepancies to be sinister. In the oil patch, both ExxonMobil and Chevron (NYSE: CVX) have considerably higher net income than free cash flow, but the disparity comes from exceedingly high capital expenditures. In Chevron's case, those expenses completely balanced out net income for an entire year. Yet unlike artificial accounting constructs, such capital investments may well bear fruit in future years -- potentially justifying themselves in the long run.
Where net income is too pessimistic
Nor should you get the idea that free cash flow is always less than net income. With Verizon (NYSE: VZ), a huge charge related to layoffs hurt net income, but free cash flow growth was much more optimistic.
Sometimes, in fact, net income seems like the better indicator. Ford Motor (NYSE: F) wrote off nearly $7 billion in amortization and depreciation during the past 12 months. It makes sense that Ford should benefit from past capital investments. But eventually, the equipment and other property that Ford depreciates each year will need to be replaced. So to get a fair long-term view of the company, it only makes sense to take those huge investments into account in some way -- and taking some amount of depreciation as a hit to income each quarter is a reasonable way to do so.
Look closely
Free cash flow isn't inherently better or worse than net income. Rather, it's just another way of looking at a company's financial results to get at the truth behind the numbers. When there are big differences, it pays to understand why -- sometimes, what you learn will change the way you look at your investments.
