Fundamental Analysis (Part 4): Financial Ratios & Valuation

16 Nov

The Cash Flow Statement

PinoyInvestor Academy - Fundamental Analysis - cash flow statement

The cash flow statement shows how much cash comes in and goes out of the company over the quarter or the year. At first glance, that sounds a lot like the income statement in that it records financial performance over a specified period. But there is a big difference between the two.

What distinguishes the two is accrual accounting, which is found on the income statement. Accrual accounting requires companies to record revenues and expenses when transactions occur, NOT when cash is exchanged.

At the same time, the income statement often includes non-cash revenues or expenses, which the statement of cash flows does not include.

Just because the income statement shows net income of $10 does not means that cash on the balance sheet will increase by $10. Whereas when the bottom of the cash flow statement reads $10 net cash inflow, that’s exactly what it means. The company has $10 more in cash than at the end of the last financial period. You may want to think of net cash from operations as the company’s “true” cash profit.

Because it shows how much actual cash a company has generated, the statement of cash flows is critical to understanding a company’s fundamentals. It shows how the company is able to pay for its operations and future growth.

Indeed, one of the most important features you should look for in a potential investment is the company’s ability to produce cash. Just because a company shows a profit on the income statement doesn’t mean it cannot get into trouble later because of insufficient cash flows. A close examination of the cash flow statement can give investors a better sense of how the company will fare.
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3 Sections of the Cash Flow Statement

Companies produce and consume cash in different ways, so the cash flow statement is divided into three sections: cash flows from operations, financing, and investing.

Basically, the sections on operations and financing show how the company gets its cash, while the investing section shows how the company spends its cash.


1. Cash Flows From Operating Activities

PinoyInvestor Academy - Fundamental Analysis - cash flow statement 2This section shows how much cash comes from sales of the company’s goods and services, less the amount of cash needed to make and sell those goods and services. Investors tend to prefer companies that produce a net positive cash flow from operating activities.

High growth companies, such as technology firms, tend to show negative cash flow from operations in their formative years. At the same time, changes in cash flow from operations typically offer a preview of changes in net future income. Normally it’s a good sign when it goes up.

Watch out for a widening gap between a company’s reported earnings and its cash flow from operating activities. If net income is much higher than cash flow, the company may be speeding or slowing its booking of income or costs.


2. Cash Flows From Investing Activities

This section largely reflects the amount of cash the company has spent on capital expenditures, such as new equipment or anything else that needed to keep the business going. It also includes acquisitions of other businesses and monetary investments such as money market funds.

You want to see a company re-invest capital in its business by at least the rate of depreciation expenses each year. If it doesn’t re-invest, it might show artificially high cash inflows in the current year which may not be sustainable.


3. Cash Flow From Financing Activities

This section describes the goings-on of cash associated with outside financing activities. Typical sources of cash inflow would be cash raised by selling stock and bonds or by bank borrowings.

Likewise, paying back a bank loan would show up as a use of cash flow, as would dividend payments and common stock repurchases.
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Cash Flow Statement Considerations

Savvy investors are attracted to companies that produce plenty of free cash flow (FCF). Free cash flow signals a company’s ability to pay debt, pay dividends, buy back stock, and facilitate the growth of business. 

Free cash flow, which is essentially the excess cash produced by the company, can be returned to shareholders or invested in new growth opportunities without hurting the existing operations. The most common method of calculating free cash flow is:

PinoyInvestor Academy - Fundamental Analysis - free cash flow

Ideally, investors would like to see that the company can pay for the investing figure out of operations without having to rely on outside financing to do so. A company’s ability to pay for its own operations and growth signals to investors that it has very strong fundamentals.

Financial Ratio Analysis

The figures appearing on the company’s financial statements are not enough to present a complete story of the overall financial performance of the business. To understand the company’s financial health, the investor must conduct financial analysis and compare the company’s financial ratios with standards, goals, or industry averages.

There are several types of financial statements analysis. Among them are analysis related to breakeven point, profitability, liquidity, activity or asset efficiency, and debt or leverage. These ratios are briefly summarized and explained below.

PinoyInvestor Academy - Fundamental Analysis - breakeven analysis

PinoyInvestor Academy - Fundamental Analysis - profitability analysis

PinoyInvestor Academy - Fundamental Analysis - liquidity analysis

PinoyInvestor Academy - Fundamental Analysis - efficiency analysis

PinoyInvestor Academy - Fundamental Analysis - debt analysis

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A Brief Introduction to Valuation

While the concept behind discounted cash flow analysis is simple, its practical application can be a different matter. The premise of the Discounted Cash Flow (DCF) method is that the current value of a company is simply the present value of its future cash flows that are attributable to shareholders. Its calculation is as follows:

PinoyInvestor Academy - Fundamental Analysis - valuation

For simplicity’s sake, if we know that a company will generate $1 per share in cash flow for shareholders every year into the future, we can calculate what this type of cash flow is worth today. This value is then compared to the current value of the company to determine whether the company is a good investment, based on it being undervalued or overvalued.

There are several different techniques within the discounted cash flow realm of valuation, essentially differing on what type of cash flow is used in the analysis. The dividend discount model focuses on the dividends the company pays to shareholders.The cash flow model, however, looks at the cash that can be paid to shareholders after all expenses, reinvestments, and debt repayments have been made.

Conceptually, they are all the same, as it is the present value of these streams that are taken into consideration.

As we mentioned before, the difficulty lies in the implementation of the model as there are a considerable amount of estimates and assumptions that go into the model. As you can imagine, forecasting the revenue and expenses for a firm five or 10 years into the future can be considerably difficult!


Ratio Valuation

On top of the financial ratios above, there are what we call valuation ratios. Valuation ratios help us gain some understanding of the company’s value (i.e. whether it is undervalued or overvalued). The most well-known of these are price-to-earnings (P/E) and price-to-book value (P/BV). The latter compares the company’s price per share to its book value.

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The ratios are compared on an absolute basis, in which there are threshold values. For example, in price-to-book, companies trading below ‘1’ are generally considered undervalued.

Valuation ratios are also compared to the historical values of the ratio for the company, along with comparisons to competitors and the overall market itself.

PinoyInvestor Academy - Fundamental Analysis - ratio analysis

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Posted by on November 16, 2014 in Academy


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