Not All Earnings are Created Equal: Follow the

Cash - Jim Fink

Author: Tan KW | Publish date: Sat, 12 Oct 15:29

By Jim Fink on June 18, 2012

One of my favorite sayings comes from Aesops hawk and nightingale fable. A hawk captures a
nightingale and is about to eat it when the nightingale, fighting for its life, tries to convince the hawk
otherwise. The nightingale argues that it is too small of a bird to satisfy the hawks appetite and the
hawk would be better off capturing larger birds. The hawk replies:

I should indeed have lost my senses if I should let go food ready in my hand, for the sake of pursuing
birds which are not yet even within sight.

Cash is King
The lesson of the story is summed up in the saying A bird in the hand is worth two in the bush.
Leave it to Ancient Greece to give us one of the most important lessons in investing. Ive used this
saying to explain why dividend-paying stocks should be an important part of your portfolio and Im
using it again today to argue that a companys cash flow from both operations and investments is
more important than its earnings. To hear this may shock you because the media always touts
earnings as the quintessential measure of a companys financial performance.

Accounting 101
Under generally accepted accounting principles (GAAP), the definition of earnings is the change in
owner equity plus dividends (if any). Earnings are shown on the companys income statement, which
is nothing more than a measurement of the change between balance sheet items. As legendary value
investor Ben Graham wrote in his equally-legendary investment book Security Analysis:

The meaning of any income statement cannot properly be understood except with reference to the
balance sheet at the beginning and the end of the period.

Since owner equity is equivalent to assets minus liabilities, earnings can also be thought of as the
change in net assets (i.e., change in assets minus change in liabilities). Liabilities are by definition not
cash and there are many different non-cash assets (e.g., inventory and accounts receivable).
Consequently, earnings often differ markedly from cash flow.

Earnings Can Be Manipulated

There is a lot of room for accounting discretion when dealing with non-cash assets. For example, a
retailer that sells $110 worth of clothes on credit has to decide whether to book sales for the full $110
or book a lower number to take into account the likelihood of customer returns. Similarly, a company
with work-in-process inventory has some leeway in valuing that inventory the higher the valuation,
the higher the earnings now. If customer merchandise returns come in higher than provisioned for, or
inventory is sold for less than its stated value, future period earnings will take a hit.

On the liability side, there is significant discretion in how to book cash outflows as current period
expenses or later period capital investments. The more that cash outflows are capitalized, the higher a
companys earnings will be in the current period and the lower they will be in future periods (since the
investments will need to be systematically depreciated, which is an expense).

The bottom line is that unusually high accruals now due to aggressive accounting will maximize
current earnings but by necessity will result in lower earnings later (assuming no growth in earnings).
The corollary is that unusually low accruals now due to conservative accounting will minimize current
earnings but result in higher earnings later.

Cash Flow Isnt Perfect Either

On the other hand, cash is, well, cash and there is no room for subjectivity (absent fraud). Thats the
good news. The bad news is that cash flows can be very lumpy and not indicative of the continuous
liabilities they are associated with. For example, if a health club collects a two-year membership fee up
front in cash, the cash will all show up in the current year, making the company look more profitable
than it really is given that the cash is tied to a service obligation that lasts for two years. The reason
GAAP accounting exists is to help match a companys assets with its liabilities in a more relevant way
that demonstrates the true profitability of the company.

Accrual Earnings or Cash Flow, That is the Question

So, that background sets up the dilemma. GAAP accrual accounting is more relevant to assessing
corporate performance but subject to inaccurate estimation, whereas cash accounting is somewhat
less relevant to corporate performance but is much more accurate.

The difference between earnings and cash flow is called accruals. The equation is simply:

Accruals = Earnings Cash Flow from Operations Cash Flow from Investing

Professor Richard Sloan and Accrual Ratios

Enter UC-Berkeley accounting professor Richard Sloan. Hes written a number of academic papers
comparing the future 12-month stock performance of companies that report earnings with a high
degree of accruals versus companies that report earnings with a lower degree of accruals (i.e.,
earnings closer to, or even below, cash flow). Specifically, he measures the degree of a companys
accruals by an accrual ratio, which divides total accruals by the companys net operating assets
(NOA). NOA equals non-financial assets minus non-financial liabilities, which is a form of invested
capital. The NOA calculation is a bit difficult so you can use total assets as an approximation.

Sloans conclusion is that companies with low accrual ratios outperform companies with high accrual
ratios. In fact, for the 40-year period between 1962 and 2001, buying the lowest accrual companies
and shorting the highest accrual companies resulted in an average annual compounded return of 18%,
more than double the S&P 500s 7.4% annual return over the same period.

Most Investors are Lazy and Dont Analyze Financial

Statements
Professor Sloans rationale for this outperformance is that investors are nave, making their investment
decisions on earnings alone without taking into account the composition of those earnings. They value
the earnings of a high accrual company just as highly as the same earnings of a low accrual company,
even though the high accrual companys earnings are more likely to reverse in future years. When
future earnings reverse, investors are surprised and sell off the stock causing the stock price to
decline. Similarly, when a low accrual companys earnings accelerate in future years, they are
surprised in a good way and bid up the stock price.
Well, dear readers, you no longer need to be nave and surprised. I ran a screen on my trusty
Bloomberg terminal for stocks with low and high accrual ratios. The low ones may be good buys and
the high ones may be sells (further research is required). Keep in mind that Sloans performance
numbers are based on averages. Not every individual stock that met his accrual ratio criteria
performed as expected.

Low Accrual Ratios (Potential Buys)

Cash Flow Cash Flow
Total Accrual
Company Earnings from from Accruals Industry
Assets Ratio
Operations Investing

Cypress
$92 -$213 $762
Semiconductor $265 million $40 million -28% Semiconductors
million million million
(NasdaqGS: CY)

Automatic Data
$1.37 $8.57 -$9.1 $39.38 Payroll
Processing $1.90 billion -23%
billion billion billion billion Processing
(NYSE: ADP)

Motorola
$818 $2.31 -$2.14 $12.4 Communications
Solutions (NYSE: $649 million -17%
million billion billion billion Equipment
MSI)

Marriott
$201 -$204 -$670 $6.17
International $1.08 billion -11% Hotels
million million million billion
(NYSE: MAR)

H&R Block $338 $250 -$547 $4.85

$635 million -11% Tax Preparation
(NYSE: HRB) million million million billion

High Accrual Ratios (Potential Sells)

Cash Flow Cash Flow
Total Accrual
Company Earnings from from Accruals Industry
Assets Ratio
Operations Investing

Endeavor
$-159 $535 $1.40 Oil & Natural Gas
International -$45 million -$649 million 38%
million million billion Exploration
(NYSE: END)

Colfax Corp. -$108 $1.67 $6.13 Industrial

-$57 million -$1.72 billion 27%
(NYSE: CFX) million billion billion Machinery

Lions Gate
-$37 $679 $2.79 Movie Production
Entertainment -$163 million -$552 million 24%
million million billion & Theaters
(NYSE: LGF)
 Clean Energy Natural Gas
-$70 $142 $927
Fuels (NasdaqGS: $-36 million -$175 million 15% Transportation
million million million
CLNE) Fuel

Tesla Motors -$295 $91 $761 Auto

-$121 million -$265 million 12%
(NasdaqGS: TSLA) million million million Manufacturing

Source: Bloomberg