In an attempt to explain the subtle but important distinction between cash flow, revenue and income, this article is the first in a series on basic investment strategy, and can serve as a primer for anyone interested in a more “rational” approach to financial research and analysis…
The first thing most people do when they hear about a new company is follow the ever-popular “share price” line of simple deductive enquiry (“Where’s it trading?” “Where was it trading?” Where will it be trading next week?”). In essence, these people are making the fairly respectable gamble that it really is “good news” that drives share prices up, and it really is “bad news” that drives them back down again. To be sure, many great fortunes were brought into being under the seemingly infinite wisdom of “Buy Low, Sell High”. Unfortunately, for you and me and just about everyone else out there who didn’t put the “dot.com boom” through its proper investment paces, many great fortunes were also lost.
So what exactly went wrong when the dot.com “boom” finally went “bust”? Were the “haves” and the “have-nots” finally shaking hands? Did the west simply change the way it spends its money? Better still — for all you eager investors out there — did it also change the way it chooses to make it? Such are the questions of the Rational Investor, just a few among many in the weeks and months to come, but all with the very same purpose: to inspire critical thought about where you spend your investment dollars.
Was it really bloated wallets and “keeping up with the Joneses” that drove Western consumers into that unsustainable frenzy of “irrational exuberance“? Did Britney Spears kill the personal savings account? Did the value of everything but oil and steel actually collapse with the dawn of the low-cost Chinese import? And who is making money because of it?
In the midst of all this overwhelming information, you the investor must find out which securities are best suited to your own particular financial taste, be they shares in Nortel, debt in United Airlines or complex derivatives in commodity-grade pork bellies. How you find out about your investment options is your own business. Tips from colleagues, names from newscasts, loose-lipped brother-in-laws and even singular moments of personal financial clarity are all great places to start. Just remember: no matter how much you already know about an investment opportunity — especially if it’s just a string of letters — the real “trick” is to always know more.
first things first
Find out more. “Who the company really is”, “What they really do”, “Why they really do it” and finally “How much they really get paid” (that last part being the hardest). Remember, “revenues” and “sales” can be pretty shady things in the right creative hands. “Money” doesn’t always mean “cash”, so it’s important to know what the company is really doing to generate value. Asking the right set of questions can give the Rational Investor a glimpse into the company’s underlying business model, and provide an early indication of its basic corporate health. “What do they buy?”, “How much do they pay for it?”, “How much it costs to turn it into something else?” and “How much do they make when they sell it?”
All are great questions to start, and flow naturally from one into the other like the blood of a giant industrial machine:
step 1) requisition of materials (goods and/or services)
step 2) conversion of materials (industrial and/or technological processes)
step 3) sale of converted materials (goods and/or services)
step 4) repeat
Take, for instance, everybody’s favourite capitalist anti-hero: Microsoft.
step 1) Microsoft “requisitions materials” like concrete and steel to build elaborate rural “campuses“, then buys thousands of computers to furnish them all, then miles of cable to connect them, and finally first-quartile talent to actually use them
step 2) the company “converts” those same raw materials through construction at first, and then through computer programming, into the most popular suite of software on the planet
step 3) the company then “sells” the resulting software as licensed “Microsoft” products
step 4) Microsoft takes all the money it makes and reinvests it in research and development, with the hopes of upgrading/improving its existing software to the point where people might be willing to buy it again
Now for contrast, take the omnipresent Wal-Mart.
step 1) Wal-Mart “requisitions materials” by purchasing large quantities of bulk goods
step 2) it then distributes those packages on-demand to over 5,000 retail locations around the globe, with what also happens to be the largest private workforce in North America
step 3) the company then sells the goods within those packages to the millions of customers daily who are willing to spend a few cents less on a tube of toothpaste
step 4) Wal-Mart then takes those dollars and uses them to replace the purchased goods on their shelves as quickly as possible, starting the process all over again
That makes two very important things to notice here:
1) all companies are essentially the same
2) three out of the four things that all companies do involves spending money
In this particular regard, companies are no different than people: they need money to survive, they only have so much to begin with, and if they don’t make more than they spend, they can easily go broke. Why then do investors try to claw each other to death in the capital markets simply to buy themselves a name (or worse still, an acronym)? What ever happened to the value of financial solvency? What ever happened to making more than you spend? What ever happened to profit?
net-net: the final frontier
Profit is whatever’s left over after paying out everyone who needs to get paid. That includes employees, suppliers, phone companies, landlords, lunch ladies, garbage collectors, mandatory interest charges, corporate/property taxes and even investment banking fees. Hence the term “net” when discussing the “bottom line”: it adds up all the sales a company has made, then subtracts all of their costs. Great! That was easy. Now you know everything you need to know about corporate finance!
For the sake of my aging keyboard (and your own precious time), I honestly wish that were true. But they wouldn’t call it “creative” if accounting was totally rigid and altogether unrelenting. And they wouldn’t throw guys in prison if there weren’t billions of dollars involved…billions of hard earned dollars supplied by investors just like you. So is accounting really evil? Perhaps…but within that cantankerous pile of refuse we call a set of “financial statements”, there are still a few numbers that actually do help. And no…”profit” isn’t one of them.
You see, profit itself is inherently flawed because it involves an unsettling amount of subjective input (i.e. GAAP-based accounting). Basically, GAAP is a standardized method of bookkeeping that allows for the matching of revenues and costs. Sounds helpful enough, doesn’t it? The problem is, giving companies the latitude to report their “profits” based on their own estimates of when expenses are incurred and when revenues are collected can be quite problematic (and often misleading) for the general investing public, not to mention extremely subjective and altogether messy.
Take, for instance, a high-flying sales manager at the end of a busy year. Rather than book his last few December sales right away (and risk inflating his boss’s expectation for next year), he arranges for the sales to be consummated in early January. Not only does this allow him to manage his boss’s budgetary expectations and avoid excessive taxation, but he also starts off his next fiscal year with a bang. In this same way, and with the same basic motive, companies can manipulate when and how they report their “sales” and when and how they expense their “costs”, effectively smoothing out their profits or inflating their underlying value as the Chief Financial Officer sees fit.
As you might recall, profits are not only a key determinant in direct compensation programs for senior executives (based on positive movements in the company’s “earnings”) but also in their options-laden incentive packages (based on positive movements in the company’s “share price”). Thus, company administrators have an obvious financial motive to inflate “profits”, not only to pad their own pockets with lofty cash bonuses, but also to drive share prices artificially higher and inflate the value of their bonus. Remember, option values rise as share prices rise, and share prices rise as “profits” rise.
“Profits”, however, can rise for a number of different reasons. In the best-case scenario, a company can actually alter its business model in a way that somehow generates more value after-tax (i.e. dropping a failing product line or expanding into a complementary high-groth industry). Alternatively, a company’s “profits” can increase through exogenous corporate benefits like a decrease in the tax rate or a drop in the cost of raw materials. But more often than not, “profit trajectory” only ends up changing when a company decides to “fudge” its numbers and “overstate” its performance, forcing a Rational Investor to look elsewhere for an adequate picture of a company’s overall financial health.
At this point, given profit’s rather fickle tendencies, it isn’t surprising that most analysts have latched onto other less-subjective measures of financial performance to deduce the inherent values of today’s increasingly complex publicly-traded companies. But exactly what do these profit “proxies” really mean? And are they really that much better?
the quest for clarity
In accordance with modern securities law, your typical publicly traded company is required to release financial reports at least four times a year. Those reports can often be hundreds of pages long and contain a whole host of confusing words and numbers. At first glance, it can all seem pretty daunting. But the funny thing is, only a few of those numbers are really that important.
The one item you should always find first is a company’s “Statement of Cash Flows” (for the current quarter, the previous quarter and even the last few years). These figures alone will tell you more about a company’s financial health than all the rest of them combined. So what exactly is this “statement” anyway? Think of it as a measure of the amount of cash generated (or spent) in a given time period after all cash revenues are collected and all cash expenses are paid. Basically, “Cash Revenues” are revenues for which cash was actually exchanged (i.e. sales on “credit” wouldn’t count toward “cash flow” because no cash was actually collected from the customer), and “Cash Expenses” are expenses that don’t require an immediate cash payment (i.e. “accrued” expenses like depreciation cost the company indirectly but don’t actually require any money to change hands).
Perhaps cash flow’s biggest analytical asset is that it separates the company’s activities into their three fundamental processes: operations, finances and investments. A company’s “profit” is simply a combination of all three, confounded rather unnecessarily with non-cash items like depreciation and employee stock options. Therein lies the true value of cash flow as an indicator of financial health: it has the ability to pinpoint the exact point of success or failure in a company’s overall business plan.
If a chicken manufacturer is generating positive operating cash flow, but still can’t make any money, it’s possible that their financing mix is all wrong (i.e. excessive leverage). Similarly, if a company has the right amount of debt on its books and knows how to manage its capital expenditures (i.e. purchase/upgrade of physical equipment), but still can’t generate any cash flow year after year, there’s a good chance its managers aren’t “managing” all that well (i.e. sale prices might be too low, requisitions might be too expensive, or working capital might be poorly maintained).
Suffice it to say, the cash flow statement is a great place to start any rational due diligence, and despite its inherent complexity, with practice it can become a powerful tool in assessing which part of a company’s business is causing all the trouble (or better still, which part is generating all the value).
to trade, or not to trade
At that point, once you fully understand the company, their business, their finances and their outlook, you need to find out exactly why they trade the way they do. Stocks don’t represent what things are actually worth, they simply approximate what people are willing to pay for them. “Their CEO is a crook“, “their milkshake brings all the boys to the yard” and “their shit really does stink” are all great places to start. Why did one company’s share price drop 20% when they announced record sales? Why has their price gone up as they keep doing business with China?
Securities go up and down because people buy and sell them. So after describing the value of “cash flow” and the duplicity of “profit”, I’m now suggesting that their importance is only peripheral at best. They’re just two of a number of factors that influence share price. More than anything else, share prices change because people’s values change. When investor perceptions about oil supply change, stock in oil companies tends to move. When investor perceptions about political risk change, currency prices tend to move. When investor perceptions about the weather change, options can double and triple (witness the recent activity of the derivatives market in the wake of Hurricane Katrina). These securities don’t go up and down because of any specific news necessarily. They go up and down because investors give value to certain news items in different proportions on any given day.
The real trick, then, is to figure out what people are going to value next. Sounds easy, huh? Well, I’d suggest that getting out ahead of the curve on publicly traded information is one of the hardest things in this whole world to do. There are too many competing investors on the field, and some of them aren’t even human. In fact, with the dawn of program trading, most news-driven arbitrage opportunities are either priced out before they materialize, or they only exist for such brief moments in time that they almost seem better suited to the floor of a particle accelerator than the floor of the NYSE.
just tell me what to buy already
In the end, investors are left in the unenviable position of: 1) finding numbers they can trust, 2) hoping that those numbers tell some sort of compelling investment story, and 3) paying an expensive premium to even place their financial bet. So what exactly constitutes a compelling investment story? The answer is nothing less than financial fortune-telling, and involves looking out a couple of years and examining what external forces might act upon a company or an industry that might change its internal growth forecast and/or its basic profitability. Assuming the numbers are “honest” (a stretch in today’s markets, to be sure) at the very least you’ll be able to make an informed decision about any investment opportunity that may happen to come your way.
But before you even consider investing in a given security, there are three questions you should always ask first: 1) are the numbers good? 2) is the concept good? and 3) is the concept durable? The value, then, comes from discovering something before the rest of the world has the chance to catch on. And if you really think about it, that kind of makes sense. It’s always the person who first “discovers” something that collects all the fame and the fortune. Alexander Graham Bell became a very wealthy man because he got to the patent office first. In the same sense, the “Oracle of Omaha” is the second richest man in the world because he knows how to anticipate broader economic trends.
When viewed in this light, investors have actually formed a new class of real-time “knowledge brokers”, continuously valuing and re-valuing competing micro- and macroeconomic trends as their tastes (and investment dollars) ebb and flow throughout the catalogue of modern capitalism. At any one point, the right forecast by the right investor can generate a bona fide fortune. But like any major casino in any major gambling town, the sheer volume of players and the sheer number of games keep the real winners few and extremely far between.
(if you have any questions about investing or basic financial theory, feel free to write us at email@example.com)