There’s a way to analyze a stock that will put you ahead of nine out of 10 individual investors…
If you make this step part of your regular research process, it’ll help weed out nearly every “portfolio busting” stock you might be considering. It’s that powerful.
The irony is, this step is also simple. In its most basic form, all it takes is a few extra minutes. Unfortunately, too many everyday investors overlook it. That’s because, like the majority of investing’s most powerful principles, it’s often buried beneath the camouflage of “boring.”
But the truth is, this is one of the cornerstones of stock market wealth building.
So what is it?
Well, let’s start with a simple analogy…
Your daughter and your neighbor’s son across the street open rival lemonade stands…
They’re similar in all respects except one: His accepts credit cards. Your daughter takes only cash.
It’s not long before people realize the neighbor’s son accepts credit cards. This convenience attracts more customers.
Your daughter and the neighbor’s son both use the same lemonade mix, so their variable costs are the same. And they’re selling at an identical price. So their revenue-per-unit is the same. But because the neighbor’s son is attracting all these added credit-paying customers, he’s making more sales. His earnings are 50% higher.
But then something happens…
Your neighbor’s son starts to run low on lemonade mix… He realizes he needs to buy more to stay in business. But there’s a problem… He has no cash to buy more mix.
You see, none of his customers have paid cash in hours. Even though he’s earning more “profits” than your daughter, it’s all credit profit.
A few minutes later, he’s out of lemonade mix… and without any cash to buy more, business slams to a halt. It’s like an engine drained of oil, its pistons locking up.
Meanwhile, your daughter also begins running low on lemonade mix. However, flush with cash, she closes for five minutes. After a quick trip to the store, she reopens. Business goes on…
Every time you consider adding a new stock to your portfolio, remember… cash is the lifeblood of every business—not “profits.”
Over the course of your investing career, you’re going to hear countless tips, strategies, and secrets. But none of them trump this one: A business’s long-term health is only as good as its cash flow.
Anyone who invested in Enron learned this the hard way…
In the late ‘90s, huge “profits” enticed average investors to pile into Enron. However, anyone with an eye for cash flow would have seen glaring red flags. Enron was posting huge paper profits. But at the same time, it was burning through hundreds of millions in cash.
There was one earnings report, around the time Enron’s share price was about $63, which showed “blockbuster” earnings… Investors applauded the analyst-beating quarterly profit of $425 million… while ignoring the cash hemorrhage of $464 million.
We all know the result. In August of 2000, Enron was selling at $90 per share. A little over a year later, shares were at $0.61.
The profits Enron was booking have a name: “accruals.” This is what accountants call earnings that are unaccompanied by increases in cash flow. More times than not—if they persist—they spell trouble… first for the business, then the share price.
In 2011, two professors published a paper in The Accounting Review with results from a study conducted from 1998-2008. They found that companies in the top 10% of negative accruals (think plenty of cash-supported earnings) posted annual returns 5.5 percentage points better than the broad market. The companies with high accruals—earnings without cash—lagged the market by 6.1 points per year.
So what does this mean for you?
It means that your stock selection process needs to include plenty of time focused on “the cash flow statement.” In particular, you want to check what analysts call “free cash flow.”
Free cash flow is actually pretty simple: It’s the cash a company generates through its operations, minus capital expenditures. (Think of capital expenditures as big-ticket expenses necessary to maintain and grow the business.)
You can find most companies’ free cash flow on many financial websites. Morningstar.com is one example. Type Coke’s symbol (KO) in Morningstar’s “quote” box. Click on the “financials” tab. Then the “cash flow” tab. Scroll all the way down and you’ll see “Free cash flow.” See below…
How Morningstar Reports Coke’s Free Cash Flow
When you look at free cash flow, you’re generally looking for stability and growth. Coke gives us exactly that. Its free cash flow grew from a bit over $6 billion in 2009 to more than $8 billion over the last 12 months. And it did so without huge, volatile swings.
There’s an added reason you, as an investor, should be interested in free cash flow. It’s from this pool of cash that companies pay out dividends, buy back shares, and pay down debt.
So is occasional negative free cash flow always cause for alarm? Not necessarily. Sometimes it means a company is making large capital investments. This might be needed for growth. And if these investments result in a high return, even better.
But it’s your job to make this call. Is decreasing or negative free cash flow justified? Or is it a warning sign? Don’t invest a dime into any company until you know the answer.
If a thorough analysis of free cash flow isn’t part of your stock selection process, I encourage you to change that today. When you buy consistent cash-gushing businesses at good prices, long-term wealth is practically guaranteed. But if your investments are regularly burning through cash, it’s just a matter of time before they burn through your portfolio as well.
Palm Beach Research Group
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