Streetwise for Sunday, February 24, 2019
If you are a relatively new to Wall Street, then it is perfectly understandable if you are questioning if this is the Street you belong on. Yes, the markets have been volatile.
The best counsel I can set forth is that you had enough vision to see the value in a company, then have the endurance and courage to ride through the aberrations in the market and vindicate your judgment.
After all it was just a few weeks ago the consensus seemed to be that the post-Christmas rally was a dead-cat bounce that would lead the market back to its December lows.
Up in seven of the last eight weeks, the S&P 500 has barely looked back, and the voices of doom have gone all but mute. To the contrary: calls have gotten louder for the market to reclaim its record of 2,930 reached in September.
So many stocks have gained ground over the past two months that the NYSE cumulative advance-decline line exceeded the Sept. 20 peak for a fresh record.
Fine you say but what about a more proactive reaction. OK, if you want to really dig in and see the projected direction of a company then look at its cash flow. Cash is the blood flow of a corporation.
With ample cash flow, a firm can pay off debt, increase dividend payments and acquire or develop new products. Cash is financial power and no stock analysis is complete without thoroughly understanding a company’s cash flow.
However, there are various types of cash flow, so it is necessary to have a solid understanding of what is being discussed. For example, there is cash from operating activities – this is found on a company’s statement of cash flows.
Free cash flow to equity (FCFE) represents the free cash that’s available after reinvestment back in to a company, whereas free cash flow to the firm (FCFF) is a measure that assumes a company has no leverage (debt) and is used in financial modeling and valuation. Finally, there is the net change in cash. This is number is found at the bottom of the cash flow Statement.
Yet, for all its importance, many investors still pay very little attention to ratios such as cash-flow-per-share.
So, what exactly is cash flow? Quite literally, it is the cash flowing through a company during a fixed interval after taking out all fixed expenses. For example, let us assume you open the cash register on January 1, and see $1,000 in the till.
Now you run off and make widgets for the next 12 months. When you open the till on the following January 1, there is $11,000 in there. Congratulations, your cash flow for the year is $10,000.
Unfortunately, it is hard to get the financial world to agree on a single definition of cash flow. Nonetheless, the most commonly used definition is earnings-after-taxes to which you add back depreciation along with any other “non-cash” expenses.
Why do you add back depreciation? Non-cash expenses, such as depreciation, are expenses subtracted out to arrive at net income, but which require no cash outlay. (Explanations that are more detailed are readily available in textbooks labeled Accounting 101.)
Another, more refined, calculation for cash flow is termed free-cash-flow. The idea of free-cash-flow is to hone down the cash flow number by subtracting out certain necessary cash outlays.
The first of these adjustments is for cash dividends. Although dividend payments are not required, they are, in the minds of many investors, a necessary use of cash.
The second adjustment is for capital expenditures. This is cash used to buy plant and equipment and such. Capital expenditures are necessary to maintain an ongoing operation and therefore the cash required for those expenditures should not be available for other purposes.
The result is free cash flow, which is just that, cash that is free for use by the firm in any way it deems most beneficial. A screening for positive free-cash-flow is a good starting point if you are screening firms on a cash flow basis.
Note to Readers:
Save the Date: I will be teaching Portfolio Management, a series of 8 classes starting Monday, Monday 11, for the Ringling’s Osher Lifelong Learning Institute. Call 941-309-5111 for registration and information.
Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddReport.com.