Cash is a fact, earnings an opinion

Robeco’s Global Equity team uses free cash flow to screen the universe for the most attractive investment candidates for further fundamental analysis. There are many reasons to use free cash flow. Firstly, being able to generate free cash flow is an indication of a viable business. If the company runs a cash deficit on its activities, it will sooner or later require external funding. Secondly, a company uses capital expenditure to attain its growth and margin ambitions. If less capital expenditure is needed to obtain the same growth and margin targets, this is a good thing. Company management is using the scarce resources in an efficient manner to create value for shareholders. Thirdly, the amount that remains after operating expenses and taxes can be freely used to pay interest on debt, pay down debt, acquire assets, pay dividends or buy back stock. All with the promise of increasing the value for the shareholders.

When looking at the cash flow statement of an individual company one often sees three categories of cash flow: operating, investing and financing. What is the cash that results from operating the existing assets? What is the cash deployed in investments? And how is that financed?

Cash flow is the net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's cash balances or liquid assets are increasing. This enables the company to internally fund investments in its business, to pay off its debts or return money to shareholders. The cash can also provide a buffer against future financial challenges. For example, semiconductor companies that operate in a cyclical environment tend to have higher cash balances to provide for darker days.

Free cash flow (FCF) is a measure of a company's financial performance, calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base. FCF is important because it allows a company to pursue opportunities that enhance shareholder value.

‘Earnings are not the same as cash’

A lot of investors focus on the earnings development, which may give a different picture than the cash flow development. Net earnings or net income include accounts receivable and other items for which payment has not actually been received. Items that have not yet been paid for are not included in cash flow.

The landmark study that drew attention to the importance of distinguishing between reported earnings and the cash generated by a firm was done by Sloan (1996). According to Sloan, the market failed to make this distinction and this was key to finding overvalued and undervalued firms. Sloan showed that investors did not distinguish between accruals and the cash components of earnings. An accrual allows a company to record expenses and revenues for which it expects to expend cash or receive cash in a future reporting period. In Sloan’s study, a portfolio that went long stocks with higher levels of the cash component, and short the stocks with high levels of accruals was able to generate a superior return.

More studies followed, both on the 'accruals anomaly', and on free cash flow indicators as a guide to the firm's future performance. Most studies – of which, interestingly, there have been relatively few - found that FCF indicators - which are harder for firms to manage than earnings - had significant predictive ability in forecasting stock returns.

Internal research at Robeco also confirmed the forecasting capabilities of FCF yield. And these studies are confirmed by Bernstein research, that hailed free cash flow in a 2016 study called ‘Free Cash Flow is King’.

In this Bernstein study, free cash flow was defined as Net Operating Cash Flow less Capital Expenditure. The universe for the study consisted of the 500 largest stocks in the MSCI All Countries World Index, starting in 1990 until the beginning of 2016. The portfolio was constructed by going long the top quintile of stocks ranked by the (trailing) free cash flow yield (FCFY) and short the bottom quintile. The study was conducted on a global basis, but also on a regional basis for Europe, US and the Pacific. The portfolios were rebalanced quarterly. FCF yield was looked at from both a sector neutral and a non-sector neutral basis.

The outcome of the study was impressive, to quote Bernstein. The FCFY factor generated average annualized excess returns of 7% per year in the non-sector neutral version and 5% in the sector neutral version.

To detect earnings management there is one overriding principle: Cash is a fact, earnings are an opinion. To get the best estimate of what the company is making, use a cash metric rather than an earnings based metric. When using a cash metric, free cash flow yield is an effective discriminating factor in ranking stocks with the best promise of outperformance.