Why Cash Flow Matters More Than Earnings
Accounting earnings can be manipulated through depreciation methods, accrual timing, and one-time items. Cash flow, the actual money flowing in and out of a business, is far harder to fake. Enron and WorldCom reported strong earnings while cash flow deteriorated. Cash flow investing focuses on this more reliable signal of business health.
Reading Free Cash Flow
Free cash flow (FCF) equals operating cash flow minus capital expenditures. It represents the cash available for dividends, buybacks, debt repayment, and growth investments after maintaining the business. Companies with consistently positive and growing FCF have high earnings quality. When FCF significantly trails reported earnings, it suggests aggressive accounting that flatters the income statement.
Practical Screening
Start by screening for FCF yield (FCF divided by market cap) above 5%. Verify that FCF has been positive for at least five consecutive years. Compare FCF to reported net income: if FCF consistently exceeds net income, the company uses conservative accounting. If net income consistently exceeds FCF, investigate why. Cash flow investing provides a margin of safety against accounting manipulation.