Everything You Need To Know About The Importance of Cash Flow In Stock Picking

There are several relevant metrics that we can use when evaluating stocks. But one of the best measures is also one of the most frequently overlooked. Below, we’ll look at the importance of cash flow in stock picking and see what the data says.

Cash flow is a superb indicator of the financial health of a business. A company can have huge revenues, but they aren’t profitable if even more significant outgoings exceed them. 

Pulling together operation, investment, and financing cash flows into a net cash flow tells us a lot about a company’s health. Crucially, unlike profits, cash flows are seen as incredibly difficult to manipulate.

Cash Flow Basics

If you want to do a cash flow analysis, you need a company to generate three cash statements on:

A) Operating cash flow 

Operating cash flow is cash received from customers minus operating expenses like salaries, supplies, rent, etc.

B) Investing cash flow

Investing cash flow is cash spent on financial instruments of fixed assets, like machinery, stocks, or securities in other businesses, property, etc.

C) Financing cash flow

Financing cash flow is funds from owners, creditors, investors. These inputs are classified as either debt, equity, or dividend transactions on a cash flow statement.

The Importance of Cash Flow

Aside from detailing the cash-generation ability of a company, cash flow is vital in other ways. For example, investors can use historical cash flows to predict future cash flows. Additionally, it can give investors an insight into the solvency and liquidity of a firm.

Dividend Growth Strategy

In 2006, then industry veteran Richard Dahlberg shared his technique for stock picking. Dahlberg stated that companies who regularly increased dividends tended to use capital more responsibly. He liked to use cash flow yields to screen stocks.

Free cash flow can be calculated by taking a (businesses earning + depreciation & other cash charges) minus capital expenses. 

To get a free cash flow yield, you take its free cash flow per share and divide it by its stock price. Companies that generate good free cash flows can often increase dividends.

Low price to cash flow ratios is a proven metric. In a 1991 paper in the Journal of Portfolio Management titled “Further Evidence on the Predictability of International Equity Returns,” between 1970 and 1990, stocks in a Morgan Stanley index with a low price to cash flow ratio produced a market-beating 20% compound annual return.

Part of why cash flow makes such a good metric can be found in how the business invests profits. In an interview with Epoch Partners, the two CIOs suggest that earnings growth and dividends drive shareholder returns. Both come from the same source: cash flow.

Indeed, “disciplined and efficient use of free cash flow” is also cited by Morgan Stanley as a great way to identify “compounders,” i.e., resilient, durable stocks that return wealth over the long term. 

In a similar study, Aberdeen Investment Group also suggests that free cash flow is a quality-value metric tied to premium, long-term returns.

Finally, Schroders has pointed to cash flow as one of the characteristics for evaluating “quality stocks.” 

They suggest that because high-quality businesses tend to be “more cash generative,” they can also sustain higher dividend growth and more efficient services debts. 

These qualities, Schroders goes on to suggest, persist over the long term, allowing these businesses to grow sustainably.

Cash Flow vs. P/E

Price to earnings (P/E) tends to grab a lot of the investment headlines. However, this metric doesn’t always give a concrete picture of a company’s ability to generate cash. Cash flows help investors understand how much cash a business can generate. 

What Investors Should Pay Attention to Cash Flows?

Free cash flow is an essential metric for dividend investors and total returns investors.

For dividend investors, it’s more important than earnings because accrual-based accounting can give an inaccurate representation of a company’s ability to pay dividends.

For total returns investors, cash flow is a great predictor of stock returns.

How To Action This Information?

The pandemic has pulled into focus the difference between profits and cash flow. Understanding what cash flow is and how to use it to pick stocks is an essential tool for evaluating a company’s financial health. The bigger picture is crucial, but a cash flow ratio can give you an excellent insight into a business’s sustainability and future dividends.

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