Most long-term investors, including dividend-growth investors, focus on net earnings and earnings per share when they evaluate and valuate companies. However, I would argue that there is a much better way to do this! Using cash flow—specifically owner’s earnings or free cash flow (FCF)—has proven to be a much more effective method for long-term investors to both analyze and value a business.
Owner’s earnings has driven Warren Buffett’s valuation model and investing decisions for decades. In fact, Buffett spelled out his formula for calculating owner’s earnings in his 1986 letter to his Berkshire shareholders. In this article, we will look at the differences between taking an income and taking a cash flow approach to company analysis and valuation… and why we prefer Buffett’s approach (or a minor variation of it).
The underpinning of most retail investors’ fundamental analysis and valuation is income (or earnings). As such, everything flows downhill from net earnings or net income—for example, return on equity, return on assets, return on invested capital, earnings per share, and growth-rate forecasts.
What’s the problem with this approach you may ask?
In a nutshell, the problem with an earnings-based approach is that it is predicated on an accounting (accrual-based) treatment of revenue and expenses. As such, it can provide a very distorted—and frequently misleading—picture of what’s actually unfolding under behind the scenes from a true cash perspective.
As a business owner, what really matters is how much cash is flowing into or out of your pocket.
The problem with earnings is that it doesn’t accurately tell you that!
Suppose you own a lemonade stand and your accountant provides you with an income statement that shows you had a net income this year of $5,000. Sounds great and you may think you just put five-grand in your bank account.
However, being an inquisitive business owner, you ask your accountant to show you your cash flow statement. After analyzing it, you are shocked to find out that you not only didn’t put five-grand in your pocket, but you actually lost two-grand of cash out of your pocket—not such a great realization!
Which number (+$5K or -$2K) is more important to you? If you answered -$2K, you would be correct! That number represents your real operating cash flow—the amount of cold hard cash your business operations produced (gained) or consumed (lost). In this case, your lemonade stand didn’t produce $5K; rather, it consumed $2K from your pockets.
Again, the income statement represents an accounting (accrual-based) treatment of business revenue and expenses—an artificial (or paper) number that does not reflect what actually happened in terms of cash flow.
This inherent problem with an earnings (income) approach is further compounded when we flow that accounting number into a wide-range of analytical metrics… and, ultimately, into our valuations!
For example, the problem is compounded when we use one form or another of income (e.g., EAT, EBIT, etc.) to calculate earnings per share (EPS), return on equity (ROE), return on assets (ROA), or return on invested capital or capital employed (ROIC or ROCE).
The adage “garbage in, garbage out” holds true for fundamental analysis!
Now, I’m not saying earnings (income) or the income statement itself is garbage. It serves a purpose and is useful for a number of things. However, what I am saying is that net income is not the best (or preferred) source-block for our fundamental analysis and valuation.
Again, as fractional business owners, we are not primarily interested in accounting numbers but, rather, in the amount of actual cash (real value) we can pull or extract from our business—or what Buffett refers to as our “Owner’s Earnings.”
It is these actual cash earnings that we should be using to analyze our ROE, ROA, ROIC/ROCE and formulate our valuation of a company from an owner’s perspective.
An additional issue with earnings (or earnings per share) is that it does not always paint an accurate picture of risk. For example, net income could be positive (due to accounting treatments), while the company’s actual cash flow could be negative. This is a problem because negative cash flows must be covered by issuance of either debt or equity (increasing risk).
Netflix is a perfect example of this. While their income statement reflects positive (even growing) net income, their cash flow statement tells a very different story. The company has a consistent and growing cash shortage—one that is requiring the company to incur more and more debt to bridge the gap.
This highlights why cash flow should be the preferred focus of the long-term investor. If you simply looked at their income statement, you would think you were putting money in your pocket as an owner (a positive ROI). However, the reality is that you are losing cash out of your pocket (a negative ROI).
Furthermore, debt always borrows from (or leverages) future growth. In other words, you are buying an ownership stake in Netflix at a high multiple with decreasing potential for future growth and increasing risk.
This is not meant to be an analysis of Netflix. Rather, it simply highlights the weakness inherent in relying solely on income numbers as a business owner—you may be bleeding money when you think you are padding your pockets!
Now that we’ve addressed why net income is not the best figure to use in our fundamental analysis and valuations, let’s turn our attention to what is—cash flow.
All that really matters to you as a long-term investor (i.e., business owner) is how much cash flow does a business actually generate after paying (1) all expenses required to operate and (2) all capital expenditures (capex).
That remaining cash flow represents the real earnings of the owners—it’s the “show me the money” number.
To arrive at actual cash flows for a business, we have to “undo” a lot of the accounting (or accrual-based) treatments made to revenue on the income statement.
In the old days, this required a lot of work for folks like Buffett—not to mention a fairly strong knowledge of accounting. However, with the widespread adoption and proliferation in use of the cash flow statement, this work is now almost entirely done for us!
The cash flow statement is broken-down into three sections: (1) cash from operations, (2) cash from investing, and (3) cash from financing.
We are primarily interested in the first section—the cash flow produced from the actual operation itself.
The cash flow statement does the work for us by factoring in accounting treatments, such as depreciation and changes in working capital. This leaves us with a clean number—the amount of cash produced or used by the business in conducting its operations.
This number is referred to as Cash from Operations (CFO).
However, this does not represent the entire picture. As noted earlier, there is one additional use of cash that is important for us as owners—capital expenditures (capex). These are reported in the second section of the cash flow statement, which represents cash flows from investing activities.
Capital expenditures represent purchases of assets or repairs that extend the life of those assets. These expenditures are not directly reflected on the income statement. Instead, accounting (GAAP) rules require them to be expensed over the life of the asset through depreciation.
However, as business owners, these expenditures represent real cash expenses at the time they are made. In other words, we don’t pay for them over the life of the asset—we pay for them upfront and all at once (in cold hard cash).
At this point, we have a choice to make. There are two types of capital expenditures: growth capex and maintenance capex.
Growth capex represents purchases that expand the capabilities of the business (operation). For example, the purchase of a new piece of equipment with a higher output than existing equipment.
On the other hand, maintenance capex represents expenditures made entirely to maintain the current level of operations. For example, repairing or replacing a piece of equipment to restore output.
Owner’s earnings (Buffett’s preferred approach) recognizes a distinction between the two. As such, it reduces CFO by the amount of maintenance capex. The rational for this is two-fold: (1) these expenditures are required to maintain operations and (2) they provide zero growth opportunity (ROI).
In other words, these are simply required business expenses—not investments in future growth. As such, they should be treated as expenses and a use of cash by the business (i.e., cash out of the pockets of owners).
However, it can be a bit tricky to determine which capex was growth and which capex was maintenance. Most cash flow statements released by companies do not explicitly report this distinction. You can research annual reports and—sometimes—companies will have a section breaking this down for you. However, not all do this… and this additional research represents a drain on your limited time as a retail investor.
Thankfully, there is an alternative—one known as Free Cash Flow (FCF). Free cash flow simply takes cash from operations and subtracts all capex. I prefer this approach for three reasons:
To summarize, there are three key cash flow numbers you need to be aware of: (1) Cash Flow from Operations (CFO), (2) Owner’s Earnings, and (3) Free Cash Flow (FCF).
These can be a bit confusing to the new investor, but the distinctions are really quite simple. CFO represents the net cash flow from operations. Owner’s earnings subtracts maintenance capex from CFO. FCF subtracts all capex from CFO.
Now that we’ve addressed how to calculate the net cash flow for owners (either using owner’s earnings or FCF), let’s look at how this benefits us—in other words, how does that cash flow to our pockets and produce a return on investment.
Dividends reflect a direct distribution of cash flow to owners—meaning our pockets.
Stock buybacks represent an indirect distribution of cash flow to owners. The problem with buybacks is that they are purely a short-run mechanism. By reducing the number of shares outstanding, the market value of the remaining shares is increased (as is EPS). However, it is critical to understand that (1) once that money is spent, it is gone forever and (2) it is a non-growth use of the available cash.
When you receive a dividend as an owner, you can use that cash—either to pay expenses or reinvest. Thus, you can generate a return on investment on that cash. However, with a buyback, that cash only serves to boost the immediate share value—it was not invested in anything that can generate future growth (or ROI) for the company or its owners. Thus, if the company can maintain that share value over the long run, then that value will remain preserved and available to be tapped (but with no growth).
However, if not, then that cash evaporates—from the company’s capitalization and your pockets. In essence, the company is merely transferring value from one form (realized cash) to another (unrealized market value). This may be good in the short-term (if you sell shares to capture that unrealized gain); however, it is not a winning strategy in the long run because (1) that unrealized gain can quickly disappear (hence it is “unrealized”) and (2) it loses to inflation because it has no growth potential.
Making matters even worse is when a company performs buybacks when they don’t have the cash flow to support it! In this case, they borrow money (increasing debt) to fund the buybacks. This provides little to no long-run benefit to owners and erodes the potential for future growth. In far too many cases, it is a less than ethical short-run tactic used by management to fleece the pockets of the owners.
As you can tell, I’m not a fan of buybacks as a long-term investor—especially when it is done at high market valuations and/or with borrowed money! It tends to benefit only short-term investors and insiders (viz., management). In the long term, it is akin to setting fire to bundles of cash and diluting owners’ ROI. Rarely is a buyback a 100% efficient use of cash even in the short run… let alone over the long run!
Finally, reinvestment represents an indirect distribution of cash flow to owners. The company can reinvest that cash flow back into the operation to generate growth. This is beneficial when a company is able to do so at a high rate of return—namely, at a rate higher than you could achieve investing that same money yourself.
This is why—contrary to the claims of many—dividends actually matter. Beyond being the only pass-through mechanism to deliver cash flow directly to owners and forcing management to focus on cash-flow management, dividends matter as companies mature and their ability to generate future growth (ROI) on that cash diminishes.
If your target ROI is 10-15%, then a company must be able to deliver a ROI on their surplus cash flow greater than that to warrant not paying owners (you) a dividend. To learn more about the importance of dividends in investing, I highly recommend reading my articles Busting the Dividend Irrelevance Myth… Yet Again! and Do Dividends Matter—The Irrelevance Theory: Fact or Fiction?
To summarize, cash flow—rather than accounting income—is important to investors because it represents your real earnings. Those earnings can flow to your pockets in three ways: (1) dividends (direct and 100% efficient), (2) share buybacks (indirect and with highly-variable efficiency), and (3) internal reinvestment for future growth (indirect and with diminishing efficiency).
To help us visualize the differences between using net income and free cash flow in fundamental analysis, let’s take a look at MMM (a typical dividend-growth investing stock and one being highly-touted after its recent market decline) and Netflix (a typical growth stock).
First, we’ll examine the differences between the two methods and compare them to the actual results. Next, we’ll discuss the findings. Finally, we’ll look at how these differences would impact valuations.
Note: These are only presented with the goal of illustrating the potential (1) differences between the methods and (2) the benefits of using a cash flow approach. These are NOT intended to be detailed or accurate fundamental analyses—nor should they be used for investing decisions. Again, they are only being presented to highlight some high-level takeaways pertinent to this discussion.
Below is the 5-year EPS data for MMM. Based on this information, owners earned $33.27 over the period. EPS grew at a 4-year CAGR of 4.4%, with an average ROE of 47.0% and ROIC of 20.9%.
Below is the 5-year CFPS (cash flow per share using FCF) data for MMM. Based on this information, owners earned $32.98 over the period. CFPS grew at a 4-year CAGR of 1.1%, with an average ROE of 46.5% and ROIC of 20.8%.
From a book perspective (below), owners earned $39.49 per share over the period, with a 3-year CAGR of 3.0%, an average ROE of 55.6%, and an ROIC of 24.8%.
In the case of MMM, the difference between EPS and CFPS is relatively small. Furthermore, the data is fairly stable. It is worth noting that this is not typical of all companies. MMM is a large and mature company, thus its data will tend to be more stable (or smooth).
However, this does not mean that there aren’t critical takeaways from using the cash flow approach for MMM.
First, growth in cash flow is significantly slower than growth in earnings. This is critical because growth is paramount for determining an accurate valuation. If you are going to discount future earnings, it only makes sense to discount accurate earnings!
Second, MMM has aggressively engaged in share buybacks. The issue is that 28.5% of its aggregate dividends and buybacks have been funded by debt. This compounds the growth problem because management has chosen to sacrifice some of that diminishing future growth to facilitate the buybacks.
If we look at the total returns (based on market performance) for owners over the same period, we find that owners earned $55.41—much higher than either EPS or CFPS would have indicated. This is thanks to (1) the short-run impact of the buybacks and (2) the multiple expansion of the market over this period.
However, the cash flow analysis provides an indication of problems under the hood—problems that have begun to manifest themselves in 2018 and 2019. The slowing growth and increasing debt are beginning to take their toll—marked by a roughly $29 total return loss per share for owners in 2018 and a $32 year-to-date loss in 2019. This brings owner’s earnings more in line with the $33 indicated by EPS/CFPS through 2018.
The impact of the growth variance between EPS and CFPS also has a material impact on valuations moving forward—very important for investors considering initiating a position in MMM or adding to an existing position.
Based on a discounted earnings valuation model requiring a return of 10% and assuming a terminal FPE of MMM’s 5-year average of 20.1 (very aggressive), when we look at a valuation based on 1% growth vs. 4% growth, we arrive at—all other things constant—an EPS valuation of around $178 and a CFPS valuation of around $131. That’s a significant difference!
Based on current market pricing, you may feel MMM is fairly-valued or even a touch undervalued. However, if you utilize the cash flow approach—using owner’s earnings or FCF—you will find MMM to still be significantly overvalued. And I typically look for a much more conservative 15% annualized return to provide a stronger margin of safety (MOS).
To learn more about using discounted earnings to value companies, I encourage you to read my article How to Easily Value Dividend Stocks with Discounted Earnings.
Let’s take a brief look at Netflix—a growth stock example. We are going to limit our view to just EPS vs. CFPS. This will demonstrate the other end of the spectrum—a colossal difference between accounting earnings and actual cash flow!
Below is the 5-year EPS data for NFLX. Based on this information, owners earned $4.64 over the period. EPS grew at a 3-year CAGR of 111.9%, with an increasing average ROE of 12.8% (23.1% in 2018) and ROIC of 3.9% (6.9% in 2018).
If you were evaluating NFLX based on net income and EPS (accounting treatment), you would think you were living the dream!
However, an analysis of the company’s cash flows paints a very different picture.
Below is the 5-year CFPS (cash flow per share using FCF) data for NFLX. Based on this information, owners lost -$16.80 over the period. CFPS decreased at a 3-year CAGR of -45%, with an average ROE of -53.7% and an ROIC of -16.8%.
The contrast between the two views couldn’t be much starker. While things may look good on the surface… under the hood, Netflix is burning through cash at an alarming and exponentially increasing rate—and it’s coming from the pockets of its owners!
The income statement makes it appear as though Netflix is not only profitable but is becoming more profitable. However, the hidden (or at least less visible) reality is that Netflix is unprofitable and losing more money each year!
Where is the cash going and why is it not showing up on the income statement? It’s going to what accounting refers to as “other non-cash items.” In this case, $11.8 billion (that’s billion with a ‘B’) in 2018 alone for the purchase of content. Again, because that content is viewed as an asset, it is depreciated (expensed) on the income statement over the life of the asset (whatever the life of “content” is determined to be).
That content is being purchased with debt—massive amounts of snowballing debt!
Now, here’s the dilemma for growth investors… If (1) Netflix can slow the need to buy additional content, (2) the existing content can actually provide lasting value, and (3) that value can be leveraged to generate tremendous long-term growth, then things may work out for owners.
However, if it doesn’t, owners are precariously perched on a high-wire with no safety net below! That debt will have to be repaid. In essence, Netflix has borrowed on behalf of its owners against potential future growth on the bet that it can generate even more growth down the road. Because that debt has already leveraged a significant amount of future growth, the company will need massive growth to make the bet pay off.
Given the competitive nature of the streaming industry, the limited life of content, and the entrance of new players like Disney… that’s a very high-risk bet! Buying shares of Netflix means you are buying the potential for a massive amount of future (highly-questionable) growth… and doing so at a high price. That’s the definition of growth-investing risk!
To take a closer look at the growth vs. value investing debate, I encourage you to read my article Value Consistently Trumps Growth for LT Investing and What Does the Value-Growth Spread Really Mean for Long-Term Investors?
Regardless of your position on Netflix or its future, the point here is simply that cash flow analysis is critical for the retail investor! It can paint an entirely different picture of a business. You don’t want to think you are making money as a business owner (based on the income statement) only to find out that you were really losing money out of your pockets!
It’s one thing to understand that and still make a strategic bet. It’s an entirely different thing to not recognize it and unknowingly accept hidden risk inherent in a given investment.
When it comes to analyzing the financial performance of a company, not all methods are created equal.
You can utilize the income statement and focus on earnings and EPS. However, the income statement is predicated on accounting treatments—rules and principles that can distort the real picture.
Instead, I recommend following Buffett’s approach of analyzing cash flows. Whether you chose to use owner’s earnings or free cash flow, this approach will provide you with a picture of the actual cash flows in the business—flows in and out of your pocket as a fractional owner in that business!
In general, using a cash flow analysis approach will:
In the end, as long-term investors, we must view ourselves as partial owners of a business. And, when you are a business owner, what ultimately matters to you is the cash—how much you are gaining or losing.
Utilizing owner’s earnings or free cash flow removes the smoke and mirrors of accounting treatments and provides a much clearer picture of just that—it shows you the money… or the flow of cash!
If you’re interested in dividend-growth investing and/or looking for valuable insights into value investing, then you’re in the right place!
At Wicked Capital, we focus exclusively on helping others become as successful as possible with dividend-growth investing and we hope you’ll continue to return to our site to learn, grow, sharpen your skills, and find effective and positive ideas and motivation!
Soak it all in, take and use what you want, modify it to fit your unique situation, and keep building that DGI portfolio with a solid process and winning long-term investing mindset!
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