One of the great blessings derived from writing my book has been the many friends I’ve made. Friendship is such a blessing! One dear friend, David, corresponds with me from time to time and he wrote me this past week with a question. At the conclusion of the discussion, he suggested that maybe I use the conversation as the content of a blog post. David beat me to it in that I was going to ask him about sharing the matter in a blog post. Thanks, David!

By the way, David is a devoted Christian man and a very savvy investor with years of experience. He has spent much time trying to learn about the best investing methods and, in my judgment, is well equipped to teach others. I have surely learned from him. He has the heart of a steward.

David wrote me the following:

“It would be helpful to know your opinion about the way Cash Flow is calculated by Value Line and some of the analysts I know: Net Income plus Depreciation & Amortization. My concern that Net Income can include non-recurring write-offs against income whereas Cash from Operations is “cash in vs. cash out”. However, for financial analysis purposes maybe the Value Line method is preferred. Please lead me out of the wilderness on this issue.”

Well, David is right about this matter being somewhat of a wilderness.

I wrote the following back:

“I believe your thinking, as indicated by your concern, is correct thinking. My preference is the cash from operations number revealed by the statement of cash flows. Use of net income adjusted upward for depreciation/amortization is going to be an unworthy approximation of reality in many, many situations.  The net cash from operations number is the number.

It is odd that many pros will conduct financial analysis with what can be very inaccurate numbers. My only notion as to the reason behind it is once again that the market has a one-dimensional focus on accrual earnings (from the earnings report). So, approximating cash flow by choosing accrual earnings only adjusted for obvious non-cash expenses (i.e. depreciation, amortization) maintains the focus on accrual earnings. Going beyond that would shift the focus of valuation of cash flow to what is more the point, namely seeing what kind of cash flow is truly being generated from conducting business for the sake of continuing/growing operations. After all, the statement of cash flows exists for a purpose, its central purpose being to provide a report enabling liquidity analysis. Unfortunately, it seems liquidity analysis (default threat analysis should be a primal relevant theme of financial analysis when applying the concept of cash flow, one would think) is of lesser consequence in today’s world of investing.
 
Liquidity is as important as profits. But by taking accrual profit (adjusted for depreciation/amortization) and using it as a proxy for cash flow, in my view again, we are making a clear statement that accrual profits trump all else and thereby throw cold water on the cash flow statement that exists because the earnings report is not sufficient for liquidity analysis. My opinion is that the loose application you speak of is a symptom of an overall market problem that suffers with an unhealthy preoccupation with the earnings report.”
Companies today are rewarded with higher share prices today for increased profitability. That is certainly rational, assuming a proper context. An improper context, though, is that the earnings report alone is sufficient to tell the complete financial story of how well a company is running its business. The balance sheet and statement of cash flows in combination with the earnings report do provide a complete picture and that full picture is essential for determining the proper reward to dole out for performance revealed by future profit reports. Stocks can become mispriced for a lot of reasons, giving the opportunity to buy low and sell high. One significant reason for mispricing today, in my view, is a central regard for the earnings report while the financial health picture given by the balance sheet is sidelined as is the all-important checking account (my personal expression) detail provided by the statement of cash flows.
May God bless each of you.