Friday, January 15, 2010

Understanding Profits Leads to Better Investment Decision Making

After 2009’s eye popping market performance, investors need to take a moment and consider what really matters when pouring over company financial reports and earnings statements. It ain't net earnings, although to the detriment of many investors, it's the metric they hinge on. Instead its the one metric that supercedes all others, save for maybe the quality of management. That metric is cash flow.

Investors would be very well served to instead pay attention to cash flows first and foremost. While it’s widely known that earnings can be massaged, investors should be aware that not all attempts to manicure earnings are illegal. Management can legitimately make corporate decisions that have a direct effect on the level of reported earnings.

The most significant decision is the use of depreciation to influence earnings. When a business purchases property, plant, or equipment, it is entitled to depreciate that asset. A growing business will likely have capital expenditures that are significantly above depreciation levels. Such a difference is acceptable for a period of time. And cyclical businesses will likely have periods where cap ex goes up dramatically as they make upgrades or new investments.

However, whenever prolonged periods where depreciation is significantly below cap ex or the other way around, investors should take note. Such discrepancies paint an inaccurate picture of earnings, which demands that investors always examine the cash flows along with earnings. When cap ex consistently exceeds depreciation, then true earnings are actually lower than those reported on the income statement. Conversely, when depreciation exceeds cap ex, then the earnings are better than they appear.

And it’s for the above reasons that value investors typically shun away from capital intensive businesses that earn low returns on invested capital. That’s why Buffett’s deal for railroad Burlington Northern has many scratching their heads. While I’m not investing in any railroads, remember that Buffett’s advantage is the fact that he will own 100% of the business plus the likelihood that Berkshire will own it for decades, which is the only possible way he will get the value he often demands (which coincidentally happens to be pretty darn attractive for the sum of money he is putting up). People often neglect little things like the fact that Burlington’s $470 million or so in annual dividends will now go to Buffett

A good understaning of earnings in relation to cash flows will present the real performance picture.