How to evaluate the quality of earnings using free cash flow

Value investors seek to identify stocks trading below intrinsic value, an analysis which requires the ability to evaluate a company’s accounting practices. When analyzing the quality of earnings, an investor tries to determine whether a company’s financial statements accurately depict economic reality. While big winners in a portfolio can be the difference in terms of generating alpha, avoiding big losers is the most important factor in returns, according to this week’s Wall Street Week guest, noted value investor Bob Olstein.

“Long-term performance, in my opinion, is determined by your losers, not, ‘Did you get a five bagger or a Netflix?’ I am interested in where I can lose before I win,” said Olstein. “We believe at the Olstein Funds that you look at your downside risk, and I’m not talking about volatility risk in the stock, I’m talking about fundamental risk in terms of, “What is the free cash flow?” And that’s what’s missing from today’s market. Those kinds of analysts are gone.”

Olstein now manages around $1 billion dollars in the Olstein All Cap Value Fund, but largely made his name on the Street with popular institutional research product “The Quality of Earnings Report,” and his focus on risk is evidence of his accounting background with Arthur Andersen.

Watch Olstein discuss The Quality of Earnings Report on Wall Street Week:

General Accepted Accounting Principles (GAAP)-based earnings allow a company to report revenue when there is an exchange of “value,” which is a subjective measure ripe for manipulation. Most companies employ some form of accounting management to smooth out earnings, but some abuse the practice to improve perception of their stock.

Management might be motivated by a number of factors in using accounting gimmicks to maximize earnings per share. Optimizing earnings boosts the stock price, maintains the value of stock options and preserves the ability to get financing. Corporate accounting teams may choose to move earnings forward or lengthen depreciation of an asset in order to cover up what they see as a transitory shortfall, but if earnings power does not bounce back, the problem will inevitably come to roost in the future, potentially causing a major dislocation in the stock price.

While Olstein largely prefers to let numbers speak for themselves, his team does take note of management behavior.

“We do care about management. The difference is we look at management and analyze them by what they say in a series of shareholder letters, annual reports. We look at their reserves. We look how conservative they are.  We look at whether they talk about problems or not.”

Financial statements, found in the company’s quarterly and annual reports, consist of the balance sheet, income statement, and statement of cash flows and are the main sources of information for analysts in determining earnings quality.

Watch Olstein explain his investment process on Wall Street Week:

The balance sheet plays a significant part in quality of earnings analysis. Investors look to a company’s balance sheet to identify changes in reserves above historical norms and assess how long a company could withstand unforeseen financial distress. If cash reserves experience unexpected changes, it can be a warning sign.

The income statement highlights the profitability of a business, comparing revenues to expenses. When conducting an analysis of the quality of earnings, analysts will compare the most recent income statement to historical quarterly and annual income statements. If increasing costs are not matched by growing revenues, obviously it affects the outlook for the stock. All else equal, investors like to see earnings beat expectations because of revenue growth rather than cost cutting.

Perhaps the most important factor used by financial detectives is the concept of free cash flow (FCF), which shows a company’s ability to generate excess cash from operations, investing and financing activities after allocating capital toward new projects, acquisitions, dividends, and paying off debt. The statement of cash flows completes the financial puzzle, providing investors with ledger of the cash coming in and out of the business. While GAAP allows for creative accounting, cash flow, the actual exchange of cash for goods and services, is impossible to fake.

Without free cash flow, companies will have difficulty returning money to shareholders. Investors look for changes in a company’s historical trend of free cash flow in order to tip it off to potential accounting tricks that could be giving the market a distorted view of a stock.

When conducting a financial investigation, Olstein starts with free cash flow.

“First of all, does free cash flow match earnings? You just have to look at the reserves that these companies [have]. For example, AOL when they first started was deferring capitalized costs, and basically over four years their marketing costs, when it was only 18 months with their subscriber. So, that’s really false earnings.”

Free cash flow yield is a useful metric that tells analysts how much excess cash a business generates in relationship to its size, and is calculated by dividing the free cash flow of a business by its market capitalization. Free cash flow yield can also be calculated by using enterprise value instead of market capitalization. Using enterprise value would provide an analyst with a more accurate measure of the value of the firm and its free cash, while market capitalization allows an analyst to compare its P/E ratio.

Olstein also eschews the “invest in what you know” philosophy in favor of an objective analysis of earnings, believing many investors have a difficult time separating perception of a business from true economic reality.

“I remember sitting there on another network talking about PetSmart. And the reporter says, ‘but I don’t buy my dog food there anymore.’ And I said, ‘I don’t care if you buy your dog food there anymore.’ I said, ‘11% free cash flow yield.’ And that’s the way we do our research.”

The same principle applies today to General Motors (GM), according to Olstein. While auto sales are slowing in China and ride-sharing services are a threat, the market has overreacted to the company’s risks and created a strong value opportunity. Department store Dillard’s (DDS) represents another good value in the market today, accordin to Olstein, with around a 10% free cash flow yield and excess non-cash depreciation above capital expenditures. He also likes Oshkosh (OSK), a maker of specialty trucks and military vehicles.

Management is incentivized to maximize share price and never likely to be forthcoming about financial distress. While not every investor has the time and resources to be the Columbo of the stock market, before making investments individuals should take steps to educate themselves. 

The following Episode Feature originally appeared in the August 9, 2015 issue of the Wall Street Week Newsletter. Subscribe – it’s free.