For many investors, the most important aspect of investing is earnings growth. Historically, the market has favoured companies which are able to offer consistently high profit growth. In many cases, it has led to bloated valuations and high profits for investors. However, another measure could be more important than profit for the long-term success of a business and its investors.
Cash flow is king
While the old saying ‘revenue is vanity, profit is sanity and cash is reality’ may be well-known among investors, it is not always applied as it is intended. A number of companies focus on their sales growth and discuss how successful their strategies have been in delivering a rising top line when they release their quarterly updates.
However, a company can quite obviously increase sales by reducing prices. Therefore, profitability matters more than sales, since it shows the overall picture of a business in terms of its income and expenditure. But profit is also limited as a measure of the financial success of a business. It is affected by changes to asset valuations and can exclude apparent ‘exceptional’ items. It is also subject to differing viewpoints on when revenue should be recognised, which can sometimes lead to questionable accounting practices.
Therefore, focusing on cash flow is a more prudent option for investors to take. It is simply cash in versus cash out during a period, and provides the best guide as to the sustainability and overall financial health of a business.
Growth potential
Cash flow can also be accurately used to determine the upside potential of a company’s shares. Not only can it be used to value a company’s share price via the price/free cash flow method, rather it also provides guidance on the affordability of a company’s dividends. In other words, if free cash flow covered dividends by a large multiple, dividend growth could be high in future. Similarly, if dividends were not covered by free cash flow, a dividend cut or higher borrowings may be required.
The importance of cash flow extends to reinvestment potential. A business which is generating a high amount of cash flow has resources to make acquisitions, expand into new products/territories and reinvest for future growth. For long-term investors, this is likely to be the biggest driver of a company’s share price, since a larger entity with greater diversity is likely to not only generate higher levels of cash flow, but also command a higher valuation from investors.
Takeaway
While sales and profitability are important and are worth checking on a regular basis, cash flow is generally a more accurate means of assessing a company’s financial health and growth potential. In essence, it is subject to far less interpretation and could therefore provide a more accurate comparison of companies within the same sector or index. While not fool proof, focusing on cash flow could help Foolish investors to generate improved returns over the long term.