There’s an adage on Wall Street that stock prices follow earnings.
It means that if a company’s earnings increase over time, the stock price should follow. The same is true for a business whose earnings are falling.
Earnings are the most-used metric when analyzing a company. How much does it earn? How much will earnings grow? What is the price-to-earnings ratio?
It’s a very useful tool for gauging a company’s overall health.
But there’s another metric that I prefer: Cash flow. Here’s why…
Why cash flow is a better metric than earnings
Cash flow is the amount of net cash the company took in. Remember that earnings can be manipulated fairly easily. There are many non-cash items included in earning reports. Things like depreciation, amortization, stock-based compensation and various other expenses can be more or less directed to tell the earnings picture that management wants to express.
I like to use the following idea to illustrate points when thinking about stocks and companies.
Let’s say you own a business. Which number is more important to you in determining whether your restaurant is successful — the number you report to the Internal Revenue Service or the amount of money you bring home to your family every year?
Without doing anything illegal, those are going to be two very different numbers. You’re going to be able to reduce the amount of taxes you owe on your profits because of depreciation on your equipment and various tax saving strategies that you will no doubt employ.
However, regardless of what number is reported to the IRS, whatever cash you end up taking out of the business’ bank account and putting in your personal account is going to depend greatly on how much excess cash is left over after all of your bills have been paid, including interest on loans and even dividends to your investors.
That’s cash flow.
Putting cash flow to work
It makes sense that a company with strong cash flow will have a stock that performs well. But that’s not just a theory.
The Oxford Systems Trader, a research service that utilizes supercomputers to crunch vast amounts of data, determined that cash flow growth is an important component to stock market success.
This research service tests hundreds of variables in thousands of combinations to determine which criteria would lead to the best possible performance. The back-tested results over 10 years showed that the Oxford Systems Trader outperformed the market by 1,568%.
I assumed cash-flow growth would be one of those metrics, but was ready to leave it out if the computer established that it didn’t increase the results.
But it did improve performance in a very big way.
Companies with double-digit annual cash flow growth over the past five years outperformed the market by 286% when screened every quarter (as often as the cash flow figures are updated).
And, despite a very difficult economic climate over the past five years, there are more than 1,000 companies that have grown their cash flow by an average of 10% or more annually.
For example, Questcor (Nasdaq: QCOR) grew cash flow at a compound annual growth rate of more than 42% the past four years (five years ago, cash flow was negative). Questcor, a biotech company that makes a drug for infantile spasms among other indications, outperformed the market by 229% over the past year.
High-performance metal products manufacturer Haynes International (Nasdaq: HAYN) increased cash flow at a 28% annual rate over the past five years. Not surprisingly, it beat the S&P 500 by nearly 43% over the past twelve months.
And chipmaker RF Micro Devices (Nasdaq: RFMD) and its 20% annual growth rate in cash flow resulted in outperformance of 10% during the past year.
Cash flow growth isn’t the end-all and be-all in fundamental research. There are many other factors that go into picking winning stocks.
But a company that’s growing its cash flow by an average of 10% or more every year for five years is clearly doing something right and is an excellent place to start your research.
Marc Lichtenfeld is the Senior Analyst at InvestmentU.com. See more articles by Marc here.