This Is Way More Important Than Earnings

The concept of "earnings" is an accounting fiction. Oh sure, for the most part and over the long run, what companies report as their earnings comes close to representing how well they performed. But on a single quarter's or single year's basis, what gets reported as earnings may be nowhere near an accurate depiction of what actually happened.

Companies have lots of levers they can pull to temporarily report stellar earnings even when their operations are weak. Take, for instance, the "no payments, no interest for one year" deals often offered by appliance and furniture retailers. As soon as you sign the paperwork and take the item home, the store books the sale and the accounting profit. The actual cash from that transaction, however, doesn't show up until you pay the bill.

Cash flow is still king
Therein lies the problem with relying on reported earnings alone to determine a company's operational strength. The store in that example likely had to pay the manufacturer actual cash within a month or so of receiving the product, but won't see a dime from you for quite some time. Even worse for the retailer, by reporting the profit, it needs to pay taxes (also from actual cash) well before the money from that sale actually arrives.

That's an incredible disconnect between cash flow and earnings. Cold, hard cash is pouring out the door, but upon a cursory glance, the company may look extremely profitable. If all goes well, the company will make up the shortfall as the merchandise gets paid off. If it doesn't, however, all the "profits" in the world won't let it pay its own bills.

What really matters to the company and its investors is its ability to convert sales and earnings into cash. When you uncover a business that does an exceptionally good job of that, it's generally one worth owning.

Who's doing well?
Fortunately, it's not hard to find businesses that do a great job of generating cash. The ones in the table below have all reported free cash flows (defined as cash from operations minus capital expenditures) in excess of their accounting profits over the past year:

Data from Capital IQ, a division of Standard and Poor's.

As a potential investor, such operational strength helps you in two ways. First, since the companies are actively generating significant amounts of cash, you can be far better assured that their earnings are real, rather than just accounting fiction. Second, thanks to their prodigious production of cash, you're able to buy these cash-generating machines at a better price than a cursory glance at their price-to-earnings ratios would show.

Own the Titans of cash flow
At Motley Fool Inside Value, we happily look past a company's reported earnings and into its true cash-generating abilities. Only then can we tell whether it's really worth owning or if it's a dud, dressed up by clever accounting. It's that relentless focus on cash generation that has helped us stay ahead of the broader market since our 2004 launch.

If you understand the difference between earnings and cold, hard cash, and why cash is the much more important one of the two, then you've got what it takes to join us. If you'd like to see why cash flow counts for so much before joining, click here to start your 30-day free trial. There's no obligation.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of General Electric. Quest Diagnostics is an Inside Value recommendation. H.J. Heinz is a Motley Fool Income Investor pick. The Fool has a disclosure policy.