CASH FLOW

Because of some of the problems associated with earnings-based analytical formulas, more analysts are turn to cash flow analysis, which they believe gives a truer picture of how a business is being run. Cash flow, many analysts feel, levels all the accounting acrobatics that sometimes obfuscate the picture of a company. The concept is an old one in economics that says that the value of an investment is derived from its cash flow—the organization’s basic cash-in, cash-out.

Basic cash flow is most simply defined as net income plus depreciation. But, depending upon their needs and personal concepts, many investors use other definitions and measures. For example, one group of investors prefers to look for operating cash flow, which is the money generated by the company before the cost of financing and taxes. According to analysts at one investment firm, Goldman, Sachs & Co., a portfolio of stocks with the best price to operating cash flow ratio would, in 1988 and part of 1989, have doubled the return of the Standard & Poor’s 500 stock index. Today, an increasing number of analysts and investors look to current and prospective cash flow before they analyze other factors. They believe that discounted cash flow—estimated future cash flows discounted back to present value—has more potential for judging company and stock market success than earnings-based analyses. Cash flows are discounted by the cost of capital or an average of debt and equity.

Probably the best of these kinds of measures is free cash flow, which is earnings plus non-cash charges, less the capital investment needed to maintain the business (there are other definitions). It’s a measure of discretionary funds—money that can be taken from the company without jeopardizing it. Holt Value Associates, one of the leading security analysis services, introduced its Value Focus service, based on economic cash flow return on investment (CFROI) performance, and not reported accounting informa- tion. This is an example of the increasing acceptance of cash flow-based concepts today.