cash flow per share and earnings per share as valuation metrics (l): earnings per share

two types of investors, two toolboxes

In the US and increasingly in the rest of the world, investors tend to fall into two psychological types:

growth investors (like me) are dreamers.  We buy stocks based on the belief that future profit growth will be strong enough to make the stock rise in price.  Our mantra is:  better eps than expected for longer than expected.  We typically buy stock in well-managed, industry-leading companies and use projected future eps as our main tool.

value investors (the more venerable [read: older] school)are pragmatists.  They buy stocks on the idea that they are undervalued based on what one can see in the here and now–the earning power of today’s well-understood businesses + the value of assets on the balance sheets.  They are happy to buy a mediocre company whose stock is trading on the mistaken belief that the firm is truly wretched.  They often have an eye to change of control.  They use both cash flow per share and eps as tools.

eps

Looking at earnings per share growth is, I think, pretty straightforward conceptually.  Earnings go up, the stock goes along for the ride.  The problem is that forecasting earnings with a reasonable degree of accuracy  even twelve months ahead is much more difficult than you’d imagine.  The evidence is that as a group even professional securities analysts, with lots of information at their fingertips and unparalleled access to company managements, fail at doing this.

One issue is that company managements understand the Wall Street game:  show surprisingly strong earnings and you’ll look like a genius and your stock (your stock options, too) will go up a lot.  So they pressure analysts to understate earnings.  Analysts, too, since their livelihood depends on investor interest in the stocks they cover, sometimes become like home town radio announcers for “their” industry and fail to notice trouble developing.

For growth investors, cash flow per share doesn’t come up in discussion very much.  For me–and I spent a little more than half my career in value shops)–three instances where  cash flow is important stand out:

–An emerging company has spent a lot on creating the infrastructure it needs to launch its products/ services, but they haven’t caught on yet.  The firm is showing small profits, or maybe losses at present.  This situation often creates the opportunity for significant operating leverage (large profit increases from small increases in sales).  So if you can find a convincing reason that the company will be successful, it is probably a very interesting investment.

–A more established company has persistently high cash flow but small profits.  This means cash flow consists mostly of depreciation.  Put another way, the company continues to make capital investments but then spends most of its time just trying to recover its (poorly conceived) outlays.  Value investors are drawn to this kind of firm like moths to a flame–thinking that either the board of directors, shareholders or activist investors will force changes.  Growth investors, in contrast, run away as fast as they can.

–A company has two divisions, one of which provides all the growth.  This happens more often than you might think.  In fact, WYNN (which I own) is in just this position.  Macau operations provide all the profits.  To my (growth investor) mind, a situation like this can provide very good performance.  That’s provided you can convince yourself that the second division–Las Vegas, in this case–won’t turn into a black hole of losses that devours the profitable division. This is where cash flow comes in as analytic tool.

As an investor, it’s not good but it is acceptable that the second division is losing money.  But it’s a great comfort if the division is in the black on a cash flow basis, as WYNN is in Nevada.  Operating leverage can be a worry if there’s a significant chance it can turn negative.  But it can be a longer-term plus, if you think there’s a bigger chance operating leverage can eventually turn positive.

That’s it for today.  Tomorrow, cash flow per share and value investors.