Beware of Useless Profits

In theory, a company's profits fairly represent its success. After all, to legally book a profit, that company has to sell its products and services for more than the total cost of producing them. There's only one small catch -- profits are an accounting convention, and on their own, they're pretty useless.

What really matters to a company's success is its cash flow -- how much cash it receives from its customers compared with how much it needs to pay to do business. There's a subtle but critical difference between earnings and cash flow that puts them worlds apart.

Why it matters
Imagine you buy a washing machine at Sears on a no-interest, no-payments-for-a-year plan. As soon as you cart that washer out of the store, Sears books a profit on the sale. But since you don't have to pay for another 364 days, there's no cash flow to be had. In fact, since Sears has to pay its supplier well before you need to pay for the washer, Sears is potentially looking at significant negative cash flow on the deal for a few quarters.

Ouch. With too many deals like that, even a theoretically profitable company just might find itself in a world of hurt. After all, in our example, Sears still has to keep the lights on, pay the rent, and buy a replacement washer to fill the hole left on the showroom floor when you bought yours. All that takes cash; the electric company doesn't accept IOUs. That's why savvy investors -- like those of us at Motley Fool Inside Value -- focus on cash flow rather than reported profits.

In reality, profits aren't worth the financial statements they're printed on until they're converted into cold, hard cash.

Shareholder-friendly money
Not just any cash will do, either. The best kind of cash is known as free cash flow. That's money that comes into the business and doesn't need to be spent on operations or things like maintenance, repairs, upgrades, and expansion. In many cases, it's a lot truer picture of the health of the company than whatever earnings figure happens to get reported.

Fortunately, there's an easy way to get a decent handle on a company's free cash flow. Simply subtract its capital expenses from its operating cash flow to arrive at free cash flow. It takes just a few seconds more than looking up the traditional earnings number, yet what it reveals can be far more informative. Consider this list of a half-dozen companies:

For most of the firms, earnings fairly closely track cash flow. But check out the ones at the top and bottom of the list. On the surface, Advanced Micro Devices looks significantly cheaper than Simon Property Group, thanks to its lower P/E ratio. Yet looking at their free cash flows tells the opposite story.

Both companies are in capital-intensive businesses. It takes tons of money to buy and build shopping malls, which is Simon's claim to fame. It also takes significant investment to build semiconductor fabrication plants, which is AMD's. The key difference is that once a mall is built, its capital costs have largely taken place. Aside from routine maintenance and the occasional facelift, most of the heavy capital costs are incurred up front. Contrast that with AMD's fabrication plants. Those need to be significantly reworked every time a new generation of smaller, faster, and more densely packed chips comes on the market.

As a result, AMD's recurring earnings are far costlier to obtain and less valuable to shareholders than Simon's. That's an effect that would be much tougher to see without the benefit of investigating free cash flow.

Your edge
By focusing on the actual cash a company generates, you can usually get a far clearer picture of what's going on behind the scenes. Even better, you can often use that cash flow information to find companies that trade far more cheaply than their reported earnings indicate. Using just that sort of detective work to uncover bargains is how we manage to beat the market with Inside Value.

If you like the idea of owning companies that create real cash, rather than just paper profits, then join us today -- our latest issue comes out at 4 p.m. ET with two new recommendations, plus access to our archive of two years' worth of picks. If you'd rather think about it for a bit before committing, your 30-day free trial starts here. Whichever you choose, you'll become a better investor as you discover how to find the true bargains in the market.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of General Electric. Disney is a Motley Fool Stock Advisor recommendation. The Fool has a disclosure policy.