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Is somebody please able to explain the significance of the Cash fow $ V.S. EPS metric for screening? thank you
J, I am not an accountant. Maybe one will want to help answer this question..
But “Earnings Per Share” is the end result of all expenses etc. The bottom line, so to speak. “Cash Flow” adds back into the eps numbers expenses that have already happened but could not be accounted for when they happened. IE Depreciation. So these are different numbers in the end. Other items that can make a difference are receivables and payables. So I guess the significance would be, as one example… cash flow is more important than eps numbers for a company to be able to pay their promised dividends. Don And if you already know this information, which is very possible that you do. Ask a more descriptive question next time.
At our meetup, we discussed Cash Flow when discussing the A in CAN SLIM.
To explain the ratio, you need to understand cash flow, in a nutshell, cash flow measures how much cash it takes in and how much it pays out. It is a purer indicator of financial fitness, as sales and earnings numbers can be manipulated. I won't go any further as you hadn't asked and I will assume you understand the different types of cash flow metrics.
IBD uses cash flow from operations. Their research shows that leading stocks have an annual cash flow that is 20% greater than their annual EPS. Typically it is expressed as a percentage ratio, which can be computed by dividing the Difference between Annual Operating Cash flow and Annual EPS, by the Annual EPS
(CASH Flow – Annual EPS)/ Annual EPS.
Negative values are the result of either Annual EPS being greater than Cash Flow or Annual EPS being a loss; in either case it is not good.
The significance of this is one of verification. Using the example of a child with a lemonade stand, that only deals in cash and has no inventory. At the start of the day, they count what they start out with; money they need to give change for. Throughout the day they add money as the make sales and give out change, at the end of the day, they count how much money is in the drawer, take out the money for supplies (lemons, sugar and paper cups) – the difference is their profits (or earnings), which is equal to their cash flow. In the corporate world, with debt and inventory, things are not as simple, but the principles are the same. EPS looks at earnings after the accountants get through with it. Cash flow adjusts these numbers and is just looking at their bank accounts. How much money did they have in the bank at the beginning of the year and how much they have at the end of the year, after all of the additions and subtractions – much like the lemonade stand. As most companies have non-cash items such as depreciation, amortization of goodwill and changes to accounts receivable, payable and inventories, the two numbers differ. Normal, healthy companies should be able to reduce their taxes, by writing off these non-cash items which reduce their earnings. However, their cash flow, which reflects actual money coming in and expenses actually paid, should be larger as they didn’t spend money on depreciation and other non-cash items. As IBD has discovered this amount is typically larger by 20%, for growth stocks. But each industry has what would be considered normal levels of non-cash items to account for; resulting in different averages by industry. But in general, it is not a healthy sign if cash flow is less than earnings and needs to be investigated or passed on. In the cases I have investigated, it is usually because the business is having sales problems and is stuffing the distribution chain of products, you will see large increases in accounts receivables.
Keep in mind that this 20% ratio is an average and is not a firm rule. It is best used when compared to other stocks in the same industry, as different industries produce different cash flow levels. Typically, industries with large capital expenses such as Aerospace/Defense, Auto Mfg have large non-cash write-offs for depreciations which result in a higher ratio of Cash Flow to EPS. Service companies may not have as big of a difference.
In analyzing cash flow the following is the checklist that I use:
Ð Positive cash flow
Ð Cash Flow ratio that is better than others in its industry.
É Secondary (Primary if peer data is not readily available)
Ð Cash flow rates exceeding EPS by 20% or more.
Ð Is cash flow increasing year to year
I usually look at profit margins at the same time as I look at cash flow as they go together and are best used when compared to its peers.
I do have a screen for healthy cash flow that looks for a Comp Rating >95, Cash Flow vs EPS% Diff Last Year >50%, and 50-Day Avg Daily $ Trade > $6M. 84 Stocks pass this screen, if you run one yourself, you will see that High Cash Flow companies usually have strong A/D Rating, Strong EPS Ratings, SMR ratings of A or B, positive ROE, solid Earnings.
In a practical sense, I don’t include it in my screens. But, before I put any money in a stock I usually look at a company’s fundamentals, including cash flow and margins. If it lacks a 20% CF to EPS ratio, I will look at its peers. If its peers are better, I might look at its peers to see if they are the industry leader and better buy. If it has a negative cash flow, I will always dig further into the company’s annual report for an explanation or pass on it.
Some other resources from IBD:
The following article describes how using cash flow you can see many of the red flags for the Internet Dot Com bombs.
The following article covers how weakening cash flow preceded RIMMs fall.
The following article shows the relationship between Cash Flow and profit margins.
Organizer of the IBD Meetup in The Villages, FL
Very good stuff! Thanks, Don
@JBrach: If you are looking for growth companies with the liquidity needed to grow through acquisitions or through purchasing additional capital, look for companies that have a greater cash flow than its earnings. A company is considered very liquid with good potential if it has a cash flow that is at least 20% greater than its earnings.
The MarketSmith Team
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