Cash flow: an essential measure for investment analysis
February 2009
The complexities of investment analysis fill dozens of new books each year — far too many to read during your daily commute.
One important element that analysts consider is free cash flow. Barron's Dictionary of Finance and Investment Terms defines free cash flow as "the amount of cash a company has after expenses, debt service, capital expenditures, and dividends."
On a simple level, you can compare a company's cash picture to your personal finances. Most of us have homes, cars, debt, and in some cases, loans we've made to others. We take these assets and liabilities into account when we create a budget based on what we'll have left over to spend after we pay the bills. All of these factors affect our personal wealth.
The same is true in the world of corporate finance, where assets may be manufacturing facilities, inventory, and accounts receivable, for example. Typical company liabilities include the money owed to the company, the company's debt, and shareholder dividends. Notice that although none of these are actually cash, they're the equivalent of cash when evaluating a potential investment.
In general, a company's cash flow comes from three activities: operations, investments, and financing. When examining cash flow, analysts must answer questions such as the ones below to be sure their assessment covers the basics.
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How much cash was available for the last reporting period compared to prior periods?
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What's the company's pattern when it spends cash? Does it increase dividends, buy back stock to add to the value of stock held by remaining shareholders, pay off debt, or invest in new facilities or other improvements?
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Is the company considering an acquisition or merger?
Evaluations such as these take place every day at Delaware Investments. Consider three examples from recent analyses by our portfolio managers.
An international automobile company is among the holdings in some Delaware Investments® funds. Todd Bassion, portfolio manager on the Delaware Investments International Value Equity team, believes that market analysts have assessed the automobile company more harshly than its cash flow indicates. It's a $25 billion company with $5 billion in cash on the balance sheet. Its debt is self-financed, which Bassion believes is a strong advantage and has retained the holding over time.
For another Delaware Investments holding, the amount of cash available to the company has been important to the decision to retain the stock in the small- and mid-cap value portfolio long-term. The security was introduced into one of the Delaware Investments funds in late 2005, and additional shares were added the next year. Among the stock selection fundamentals that appealed to small- and mid-cap portfolio manager Chris Beck was the company's strong cash flows — more than $500 million at the time. In addition, the company's average cash flow per share was about five times the stock price per share. In late 2005, the company paid a large sum of money to acquire a competitor.
This significant factor could have been considered a negative by some analysts. Beck examined the cash flows carefully and saw that the company planned to use the free cash, along with additional expected cash flow, to pay for much of the purchase immediately. Along with other fundamentals, these numbers persuaded Beck and other members of the investment team to put the stock into the hold category at that time.
In the emerging growth investment world, technology company analysts such as Steve Catricks of the emerging growth team at Delaware Investments view cash flow from a different perspective. Many emerging growth companies are early in the corporate life cycle and are still in the investment stage. As a result, these companies may have a negative cash flow because they are investing cash in the business.
Also, specific sectors present their own challenges. The revenues of software companies, for example, could be misleading because of the general transition to new business models in this industry. Some software companies follow a traditional model in which software is sold for a specific price, and profits are fairly straightforward. Other software companies have transitioned to a model that sells software as a subscription service. In these cases, cash is generally received at the start of the subscription period. However, revenues are prorated over the length of the subscription period. In these cases, cash flow may be an indication of the growth rate of the company.
Each of these examples helps illustrate the effect of an analyst's research specific to a company's cash flows — whether the cash comes from product sales by a technology company, growth of a company through the acquisition of a competitor, or expenses saved by self-financing debt. The analysis enables portfolio managers to retain or initiate investments that may contribute to the performance of various funds. Ongoing, this type of analysis will continue to shape Delaware Investments analysts' comprehensive understanding of a company's real value.
Information in this article is not and should not be construed to be financial advice.
Delaware Investments refers to Delaware Management Holdings, Inc. (DMHI) and its subsidiaries. Macquarie Group refers to Macquarie Group Limited (MGL) and its subsidiaries and affiliates worldwide.
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