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How to Correctly Use Stock Indicators
Part 3: The Cash Flow
Fundamentally, the cash flow describes the balance between the inflows and outflows in a company over a specific period. This corresponds to the net influx of liquid assets. All transactions that do not result in actual payments are not taken into account. If the cash flow is positive, then the company is liquid and everything is in order. However, if the cash flow is negative, then the company’s cash reserves are slowly being depleted. Essentially, the balance sheet item “cash flow” competes with the balance sheet item “profit” and is used similarly in the evaluation of companies. However, the cash flow provides better information than profit about whether a company can finance investments from its own resources, whether cash is available for interest payments or dividends, and whether there is a risk of insolvency.
Cash flows are often more important than reported profits:
The indicator price/cash flow ratio (PCF) can be used similarly to the price-earnings ratio (P/E ratio) analyzed in Part 1 of this series. A stock with a low PCF is more favorably valued than a stock with a higher PCF. But why not stick with the P/E ratio? What sets the cash flow apart from profit? There are two reasons why the PCF is popular: First, ultimately, investors are interested in cash flows when evaluating stocks. What actually flows into the cash register is crucial, not what is reported as profit in the balance sheet. Second, the cash flow in the balance sheet is less susceptible to manipulation than profit. In essence, the cash flow of a year is calculated from the annual surplus plus depreciation and an increase in provisions. Depreciation and provisions, which were previously deducted from the annual surplus, are added back to calculate the cash flow. However, these two items provide the most leeway in accounting and are therefore often the target of “balance sheet cosmetic” measures by management. By calculating the cash flow, such (legal) manipulations are reversed. This is a positive aspect.
The facts:
- The cash flow is less susceptible to manipulation and therefore often more meaningful than the reported profit.
- Similar to profit in the P/E ratio, the cash flow is used to calculate the price/cash flow ratio (PCF): PCF = Current price / Cash flow per share.
- However, just like the P/E ratio, the PCF is only suitable for comparing similarly structured companies, usually within the same industry.
Our Conclusion:
If a company does not generate cash flow, it will eventually have to cut dividends and/or will be unable to service its debts. Insolvency looms. Therefore, when evaluating a company’s creditworthiness, banks and other creditors often use the cash flow. However, this balance sheet figure is also preferred when evaluating companies. It is hardly manipulable, meaningful, and easily comparable. Nevertheless, the P/E ratio is more frequently used as an indicator due to its greater availability.
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