There are so many different ways to value a stock and evaluate the health of a company. Many investors focus on earnings and every quarterly report fret about each penny per share that the company exceeds or misses estimates by. There is nothing wrong with judging a company by earnings, but that is certainly not the whole picture. In fact, in can be dangerous to just look at reported earnings.
A Better Measure
In addition to earnings, make sure to look at the company’s cash flow. More specifically cash flow from operations is the most important item in my opinion. Basically this is the amount of cash coming into the company due to the core functions of the company. No firm can sustain strong earnings growth without this measure growing too.
Cash flow is much harder to manipulate than earnings. Management can legally tweak certain things to make earnings look better in order to appease Wall Street, but cash flow is much purer. Avoid companies in which earnings are growing but cash flows are falling. Trouble is surely on the horizon for such companies.
Firms with ample cash flows have flexibility to weather bad times and to pay dividends or buy back shares. All of these are strong positives for shareholders. One reason some investors were willing to stick with British Petroleum (BP) during its legal troubles was the company’s enormous cash flows. This is also the reason that investors stick with the tobacco companies. Altria (MO) and Philip Morris (PM) pay fat dividends and throw off tons of cash despite always being involved with legal troubles.
Income-oriented investors should pay particular attention to cash flows. They buy stocks to capture strong dividends and like to see companies that regularly increase their payouts. This can only happen when cash flows are growing at a healthy pace. Even if earnings are growing, it isn’t a sure thing that the dividend will increase.
In these treacherous markets, one thing is certain: cash flow is still king.
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