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If you want to pick stocks and beat the market, you need to understand a company's cash flow. Cash allows the company to grow and invest in itself, it allows it to pay its talented workers, and, most importantly, it's the stuff that will hopefully make it back to you as an investor.

My insights below are largely adapted from Working Capital Management by Bernd Heesen. Heesen's book is focused on working capital from a business-manager's perspective, but there's a lot that investors can learn from this book that will help them find great investment opportunities.

A word before we start: This approach works primarily for asset-intensive businesses like manufacturing companies. It's not an approach that you can use with banks or insurance companies, and will typically work poorly for intellectual-property based technology and services companies.

Being able to afford latest technology is what matters
To be successful in the long term, companies need to keep up with technological developments. Think about it this way: today we find a mobile data connection of at least 7.2 Mbit/s essentially all over Germany, while just 15 years ago most house-olds were satisfied with their 100 times slower ISDN line at home. You wouldn't sign a contract with Deutsche Telekom today, if you were only offered ISDN speed, would you?

But to keep up with the latest technology requires a substantial amount of money.

For this reason, using a company's ability to finance asset replacement -- and improvement! -- with internal cash flow can be an indicator of that company's strength. This is what Heesen calls the "1,2,3 rule". And here's how it works.

Operating cash flow of:

  • 1 times depreciation means its business is strong enough to fund preservation of substance
  • 2 times depreciation means its business is strong enough to fund preservation of technology
  • 3 times depreciation means its business is strong enough to fund growth

Come on, you just picked 1,2, and 3 so that you don't have to think of a catchy name for this rule, right?
Well, there is something to it. But let me explain why this makes sense and isn't totally arbitrary. If a company earns its yearly depreciation as operating cash flow, what does it mean? It means that it is able to preserve the value of its assets in the balance sheet by investing the complete operating cash flow back into them. Agreed? Number "1", check.

This, however, won't ensure state-of-the-art technology. The latest technology usually comes with a higher price tag. And we can check the number "2" under the assumption that an asset's price tag -- due to its technological progress and inflation -- doubles during its lifetime.

If we don't use that assumption of prices doubling, we'd need to substitute it for a number that correctly reflects the economics. However, the above has generally proven to be a good rule of thumb for manufacturing and other asset-intensive companies. It's doesn't work quite as well for computer hardware though.

Completing the 1,2,3 rule
So, investing cash at a rate of two-times depreciation into your assets means that you are affording state of the art technology. But your toughest competitors are doing the same. Hence, you won't outgrow them just doing this. And this is why we have the "3" in our rule.

Admittedly, the three-times level is somewhat arbitrary. In general, as long as the money is spent well, the higher the investment, the better. And to be sure, 2.5 times is actually a good number -- but who wants to say "According to the 1,2,2.5 rule this company is a buy"?

Enough talk, let's look at some real life examples

The following table shows four DAX companies in asset-intensive industries (defined as businesses where fixed assets make up more than 40% of the balance sheet) and how I rate them based on the above – from A (good) to C (weak):

Company Average Asset Lifetime Operating Cash Flow / Depreciation Rating
Adidas Group (ETR:ADS) 15 years 2.81 B (preservation of technology)
Deutsche Telekom (ETR:DTE) 8 years 1.14 C (preservation of substance)
Infineon Technologies (ETR:IFX) 5 years 1.74 B (preservation of technology)
K+S AG (ETR:SDF) 13 years 2.97 A (growth)

Data source: annual reports of the respective companies from 2009 – 2014.

All numbers in the table are averaged over the last five years to smooth one-time effects and business cycles. I used the ratio of fixed assets-to-depreciation as a proxy for average asset life.

"Wait a minute," you might be thinking, "why did you rate Adidas a B, even though you said previously that 2.5-times is good and Adidas is well beyond that?"

There are two reasons for my rating:

  • Average asset lifetime at Adidas is 15 years -- well above the 10 years mentioned previously. So I think it's possible that asset prices more than double within their lifetime.
  • More significantly: you don't see this in the table, but the cash flow-to-depreciation ratio has been decreasing continuously in the last five years, from four in 2009 to just 1.8 in 2013.

Hence, I believe that B is a more than adequate rating.

The rating of Deutsche Telekom should be clear -- unless asset prices in this industry don't increase, the company is left to just preserve the asset value. And I doubt that it was cheaper to roll out the LTE network compared versus the 3G rollout 10 years ago. Infineon's rating is a strong B, considering the short life of its assets. I do, however, find it a bit concerning that the ratio at Infineon has also been decreasing in the last five years. Finally, in my view, K+S is a clear A rating, even if we adjust for the relatively long asset lifetimes.

The 1,2,3 rule is simple to use and provides valuable insights into the strength of a company's cash flow. It's not only useful in comparing one company to another, but we can use it to judge a specific business that we are interested in. We only need to apply some common sense when interpreting the information. And obviously, this shouldn't be your sole parameter to base your investment decision on. But it is one useful building block to separate winners from losers. In fact, I think we may have found one potential winner in the table above: K+S.

Try it out with one of your investment ideas and feel free to share your insights below if you want to discuss!

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This article originally appeared on Fool.de.