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Accounting profit vs. free cash-flow

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03/09/2019 | 05:16pm EDT

Whenever we assess a listed company - whether we want to invest in it or simply out of interest - one of the essential elements of the analysis consists of identifying that company’s actual profitability. In other words: how much of the profits that it generates are actually redistributable to the company’s shareholders?

Answering this question goes well beyond a simple reading of the income statement. Experienced investors - like business leaders - know this very well; the net result usually has nothing to do with the actual profit since its burdened with substantial ‘non-cash’ accounting adjustments, such as depreciation and amortizations.

This is why it makes more sense to refer to the free cash flow in order to count the profit generated in cold hard cash. After all, as owners of their businesses, shareholders expect to be paid in cash rather than in accounting adjustments!  

To measure the cash profit we have to - summarising roughly - look into the cash flows rather than the income statement - and subtract the investments that are required for the short-term operation (that is to say in the need for working capital) and the long-term (that is to say in tangible and non-tangible assets) from the cash that has been generated from the operations - while making sure to verify the legitimacy of the latter.  

Then we need to subtract from this first result the amounts that have been invested in acquisitions if there have been any. This clearly shows us how much cash has come in, how much cash has gone out, and especially to what uses the outgoing cash has been attributed: we can thus calculate how much is left on the table at the end of the year, ready to be distributed to the shareholders if necessary - this is the company’s free cash flow.  

Once this has been identified it’s important to understand what the company does with these profits. Does it redistribute them in full to its shareholders? Does it pile them up on the balance sheet in anticipation of a transformative investment? Does it reinvest them in its business activity entirely, often in addition to new fundraising?  

If the latter is the case, there usually isn’t any profit left to be redistributed to the shareholders. This doesn’t disqualify a prospective investment: you simply need to check if the resources are well used, and that the productive growth investments live up to the declarations of the management. 

An expeditious way to proceed consists of accumulating the annual investments - in the need for working capital, the assets and the acquisitions - and then to link them to the increase in operating profit: for any given financial year, if for example the company has invested one billion and generates 300 million of additional operating profit, the return on capital is 30% - before taxes and interest - and the virtuous circle seems a priori well underway.

The value creation, therefore, is real and, if the valuation warrants it, an investment is just as justifiable as an alternative among mature companies where the majority of the profits are redistributed with zeal and regularity.

On the other hand, and to come back on the article Dividends: a trap to avoid, if we notice that, over time, the free cash-flows don’t cover the dividends or are employed for questionable uses, this probably means that something is off and that there are serious problems lurking in the corner. In France, the shareholders from EDF and Engie - to name just two examples - have learned this the hard way.  

Finally, a different analysis - reserved, however, for the most experienced analysts - consists of separating so-called maintenance investments from so-called growth investments: we can then try to identify a ‘normalized’ profitability and postulate that the company, if it would cease to invest in its growth, would technically be able to distribute to its shareholders a profit in a masked state in its accounts.  

More generally speaking, understanding the cash flow dynamics allows us to better discern the subtleties of the business model. During a time of growth, a cyclical business like the American company Mohawk Industries, for example, devotes all of its cash flows to its investment efforts - for acquisitions abroad, to improve its productive apparatus and to provide working capital in line with the needs of the business activity; during a time of slow-down, however, the level of inventories and receivables decreases dramatically, freeing up a lot of cash and therefore boosting the free cash flow despite a net result that is limping along.   

This particular dynamic means that even in a low cycle Mohawk generates a comfortable profit, even though it’s hidden in the income statement. In times of stress, as history has proven, the company’s valuation does not always do justice to its fundamentals: it’s exactly this type of inefficiencies that an experienced investor can try to exploit.

Stocks mentioned in the article
ChangeLast1st jan.
VALUE8 -1.43% 5.5 Delayed Quote.17.72%

Neelie Verlinden
© MarketScreener.com 2019
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