By James Saft
(Reuters) - In an era in which facts themselves are increasingly under attack, investors should value what they can count over what they are told.
With that in mind we should remember that earnings can be faked and valuation is a matter of opinion but the old truth still holds: cash flows never lie.
We’ve long known that earnings, as reported by companies on a generally accepted accounting principles (GAAP) basis, can be deceiving. Not only are these numbers susceptible to the occasional spectacular fraud - think Enron - but the wide degree of latitude around exceptional items and different methods of presentation can make securities analysis more of an art than a science.
Given the current political climate under President Donald Trump there are, perhaps, reasons for investors to take a heightened interest in making sure they know what it is they are getting when they buy a share. Though Trump hasn’t announced any specific accounting related initiatives his administration favors a “streamlined” approach to regulation, saying it will repeal two regulations for every new one and conducting a review widely viewed as the death of Dodd-Frank financial regulation.
An attack on regulation, after all, may be good for corporate profits but could well make them harder for investors to trust.
This makes a new paper published in the Financial Analysts Journal especially timely, as it presents a method to better measure corporate cash flows, the life blood of any business and, it seems, perhaps the best barometer of future value. (http://www.cfapubs.org/doi/pdf/10.2469/faj.v73.n1.2)
“We believe that the lack of uniformity among reported statements and their disjointed presentations make it extremely difficult for investors to test the quality of a corporation’s historical earnings and compare the results within and across industries,” Stephen Foerster of Western University, and John Tsagarelis and Grant Wang of Highstreet Asset Management write.
“Our study shows that by using a standardized 'direct cash flow' template, investors can better understand a company’s historical, contemporaneous, and forecasted return potential.”
Most companies use an indirect method of reporting cashflow, including non-cash operating items they include in net income rather than simply operating cash receipts and payments.
The authors found their direct cashflow measure not only was better at predicting future stock returns than indirect cashflow but also than common profitability measures that use gross profits, operating profits or net income.
THE BASIC BENCHMARK
This predictive power of direct cashflow held across various investment horizons and worked after adjusting for the usual risk factors and sector characteristics. Stock of companies whose cashflow ranks in the highest 10 percent outperforms those in the bottom 10 percent by 10 percentage points annually on a risk-adjusted basis.
The study looked at U.S. stocks, measuring cashflow and stock performance for S&P 1500 index shares from 1994 to 2013.
While you could not use cashflow as a single criterion for measuring every company, getting to grips with it is essential, no matter what a company does or where it is in its evolution from a start-up to a mature firm.
“No matter whether a company makes telecom equipment, cars, or candy, it's still the same question: How much cash do we get and when?” Warren Buffett and Charlie Munger of Berkshire Hathaway (NYSE:BRKa) once wrote.
If you’ve not got a read on how much cash is flowing through a company’s coffers now, your ability to make good predictions about how investments or future business conditions will impact the cash available down the road to enrich shareholders will be impaired.
Remember too that the latitude allowed in how companies report all too often leads to them presenting an unrealistically good view of the current trading, and by extension, their future prospects.
A 2015 survey of almost 400 chief financial officers and finance executives found they themselves believe that a whopping 20 percent of firms “intentionally distort earnings, even though they are adhering (to GAAP principles).” (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2376408&download=yes)
More than a third of the CFOs said that earnings which don’t correlate with cash flow from operations, or strong earnings despite falling cash flows, were significant red flags.
As it is now quite difficult to even discern cash flows, much less to correlate them with earnings, the typical investor is left in the dark. Perhaps the direct cashflow presentation method should be mandatory.
Given that we are facing a period of deregulation and potentially growing corporate chicanery, investors shouldn’t wait for companies to do this themselves.