Cash Flows Don’t Lie

Given the current political climate and the uncertainty surrounding the financial markets, it’s important for investors to stick to concrete concepts when evaluating stocks, says an article in last week’s Globe and Mail.

The article asserts that, while earnings and valuations can be subject to “faking” due to accounting loopholes, “cash flows never lie.” It cites results of a study published in the Financial Analysts Journal that support the use of a ‘direct cash flow’ template to measure corporate cash flow and, perhaps, allow an investor to better evaluate a stock’s future value. This method measures operating cash inflows and outflows as opposed to an “indirect method of reporting cash flow, including noncash operating items they include in net income, rather than simply operating cash receipts and payments.”

The study—which looked at cash flow and stock performance for S&P 1500 index shares from 1994 to 2013–found that the direct cash flow measure was “not only better at predicting future stock returns than indirect cash flow but also than common profitability measures that use gross profits, operating profits or net income.”

The supporting argument, the article states, is that if you don’t have a firm handle on a company’s true cash inflows and outflows, “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.”

The article cites a comment once written by Warren Buffett and Charlie Munger: “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?”