Getting the Market Right: Marc Lichtenfeld on Earnings and Cash Flow
Steve McDonald (SM): This week, we have Marc Lichtenfeld with us, and he’s here to talk about cash flow and earnings. It’s all yours.
Marc Lichtenfeld (ML): Sure. There’s a very big difference between cash flow and earnings, and I think people sometimes don’t pay enough attention to cash flow.
Earnings is what the company earns. You hear about it all the time – earnings per share, net income. Cash flow, though, is how much cash the company brings into the company, and it’s very different from earnings.
Earnings has all kinds of non-cash items, like depreciation, non-cash-based compensation and stock grants. If a company gives an employee, let’s say, $100,000 worth of stock, it writes that off as an expense against its earnings.
However, it didn’t cost the company anything really, so it doesn’t come off the cash flow. That would be an extra $100,000 worth of cash flow.
So it’s really important to understand how much cash a company’s bringing in – it’s not just its earnings that have all these non-cash items. And especially in my area where – we’re talking about dividends – we want to know there’s actual cash there to support that dividend, not just earnings that have, again, all these non-cash kind of accounting “trick” items.
SM: One of the things I look at when I’m looking at a bond is the total debt, cash and cash flow.
And I look for about 10% – that’s very generous. If the company can cover 10% of its debt with either its cash or cash flow, that’s more than enough money to keep it afloat.
But what, on the stock side, do you look for in cash flow? What kind of percentage or coverage?
ML: For most companies – not a REIT or MLP or something like that – just a regular corporation, generally I want to see the company is paying out about 75% of its free cash flow or less.
So if it’s paying 50% of its cash flow in the form of dividends, then I know that it has plenty of cash to support the dividend. If next year is rough and cash flow declines, it can still support that dividend.
Anything above 75% starts to make me a little bit uncomfortable. Anything more than 100% means it’s not generating enough cash to afford that dividend, and that’s a problem.
SM: But on Yahoo Finance, for example, if you go into the statistics column and over on the right-hand side towards the bottom it has dividend ratio – isn’t that based on earnings?
ML: Exactly. Yeah, great point.
Most people base the payout ratio on earnings, and they’ll take the same ratio. If a company’s paying, let’s say, $0.50 a share in dividends and it earned $1.00 per share, that would be a 50% ratio.
But again, remember those earnings have all those non-cash items, so it’s not that accurate of an indicator of whether a company can pay the dividend. So that’s why I use the cash flow because it’s only accounting for the cash that came in.
SM: I rarely see cash flow per share, though. How would you calculate that?
ML: You take the cash flow and divide it by the shares outstanding. It’s the same way you calculate earnings per share, but you use the cash flow number.
SM: Do you feel like cash flow is a more accurate measure of a company’s health than its earnings? Because earnings can be a magic number.
ML: Yeah, cash flow is much harder to doctor. If a company’s going to commit outright fraud, it can still do that with cash flow by playing some tricks with accounting.
For example, if a company makes a sale on December 30, it might count toward revenues and earnings for that year… but if it doesn’t get paid until January 30, it doesn’t count toward cash flow because it counts only when cash comes in the door.
So if a company is stuffing the channel, it’ll try to get a whole bunch of sales right at the end of the year or the quarter to still count toward earnings. And it’ll beat its number, and the stock will go up. But it’s not necessarily an accurate reflection of how the business really performed.
SM: That’s interesting. Thanks so much for being with us. Always a pleasure.
ML: My pleasure.
About Steve McDonald
Somewhat of a renaissance man, Steve worked as a professional broker and has been an active trader of bonds for more than two decades, specializing in ultra-short-maturity corporate bonds. But before entering the investment industry, Steve was a naval aviator, flying fixed-and rotary-winged aircrafts, and also served as a surface warfare officer. Steve’s regular video series featured on Wealthy Retirement called “Slap in the Face” Award is some the most amusing investment content we republish.