My thinking is different from most investors, but it wasn't always like that. Like many, I started out in covered calls as a sprinter, wanting to get back to cash every month to start over. That was until I got interested in value investing and changed my strategy into more of a marathon.
I look at the stock market a lot differently now. I no longer think in terms of stocks and stock prices. Instead I treat investing from the business owner perspective. The stock market is just a place to buy and sell businesses.
I determine how well a business is performing based on it's Statement of Cash Flows. The other metrics that Wall Street uses, like EPS, can be faked by accounting. But cash is king. A company that doesn't generate enough cash to pay for it's operations is doomed to fail. Enron was a prime example. They had negative cash flow for years before their collapse, while their EPS was skyrocketing due to fake accounting. So, I look for companies that generate more cash than they spend.
Think about this for a minute. If you earn more money than you spend, and have some left over to invest, your net worth and income will grow. Well, it's no different for businesses.
Balance Sheets and Incomes Statements are primarily used for tax reporting and therefore don't reflect the true picture of how well a business has performed. Do you measure your annual performance by your tax return? Probably, not. So why do that for businesses?
Wall Street focuses on the Income Statement to calculate EPS and P/E ratio, however these are not a true picture of valuation.
Most businesses use the "accrual" method of accounting, meaning they book sales when the orders are placed, not when they receive the payments. For major purchases/expenses, they depreciate/amortize them over time rather than record the actual amount paid. This can inflate their earnings and show positive earnings even when cash flow is negative (e.g. Enron). While this is fine for tax reporting, it doesn't tell prospective business owners (i.e. investors) how well the actual business performed.
The Statement of Cash Flows is the heart of a business, since it reports how much cash was generated, how much cash was spent, and how much cash is left over for paying dividends and re-investment into the business. Without cash, a business can not grow. So, this is the primary metric that I look at when analyzing a business.
I've known about cash flow for some time, since I'm a follower of Graham/Buffett. Buffett calls this owner earnings, which is slightly different from free cash flow. It's more involved to calculate owner earnings, since you need to dig into the financial statements to pull the information you need. A simpler approach is to use free cash flow, which is Cash from Operations minus Capital Expenditures. For large stable companies, like the type I usually invest in, using free cash flow is fine, although the results tend to be a bit higher than owner earnings.
This is all explained in easy to understand terms in Joe Ponzio's new book entitled "F Wall Street: Joe Ponzio's No-Nonsense Approach to Value Investing For the Rest of Us
". This is probably one of the easiest reads on value investing I've read. I've followed Joe's F Wall Street blog almost since the beginning and have learned a lot from him. Thanks Joe!
