The number the directors don't want you to find - MoneyWeek Investment Tutorials

in this video we're going to focus on which number should you look at as an investor in these tricky volatile times with share prices leaping and then plummeting mainly plummeting recently of course how can you be sure that you're buying the right investments and which number should you be looking at when you do now the directors of a company would like you to focus on profits and the profit and loss account and earnings per share and all those good things as they see it and I've already made some videos on earnings per share what it tells you what it doesn't price earnings ratios based on that there's also one on what is profit the problem and I highlight it in those videos is you can't always trust the profit figure the profit and loss account comes first when you look at the primary financial statements profit loss account balance sheet cash flow statement but you simply cannot always trust the profit figure why not quick summary two good reasons why you need to be wary of the profit figure and then I'll reveal the number that actually right now you ought to be looking at you don't get four three from the company normally and that's because the directors would probably in a lot of cases rather you ignored it okay more about that number in just a moment what's wrong with profit well I've done a video on what profit is all about so I won't labor the point here I'm not going to run all the way through profit and loss accounts please do check out my other videos for that one however just bear in mind profits are based on something called the matching or accruals concept in a nutshell what that means is this in a profit and loss account for twelve months you capture all of the activity of the business regardless of whether cash has been received or paid very simple example there are others he imagined by the 31st of December my financial year end I've build clients a hundred and fifty thousand pounds for work done as a firm what that means is I can put 150,000 pounds of Revenue in my profit and loss account okay however if I hadn't collected any of the cash by the time we hit the year-end the balance sheet date the cash received is zero so here's the point that profit and loss accounts that's just one difference capture activity so on the revenue side that means if you've done the work and billed for it send out the invoice then you can book the sale so if you like it is a trading statement however with cash flow statements you don't recognize any of that revenue until you've actually got a check from your customer okay so there's one fairly fundamental difference so what I'm suggesting here is there are items in the profit and loss account that are not always cash backed why is that matter because when it comes to the crunch cash is king one of the directors going to pay your dividends with ultimately it's got to be hard cash what's going to determine whether the company survives or not ultimately hard cash the other thing which I'll mention is a set for a point is profits are full of estimates now if you're getting lost at this point do see my what is profit video but I'll give you one very common example - the depreciation or what Americans like to call the amortization spell it with the Zed for good measure basically this is the way that the directors deal with big capital costs so you spend a million pounds on plant machinery what do you do with that cost in a profit and loss account you decide how long you think that machinery is going to last ten years and you book a tenth of the cost through ten years profit and loss accounts based on the idea it will take ten years to wear it out before you need to replace it in cashflow terms very different picture we spend 1 million on a piece of plant machinery nubuck 1 million as an outflow in the cash flow statement so my point is this profit and loss accounts are fine profit as a measure of performance is ok but in the current climate in particular you cannot simply trust profit figures you've got to do some more work and there is a number which is a vital insight into whether the business is actually managing to back up what it claims in the profit loss account with hard cash ok so what is that number well it's called free cash flow sometimes abbreviated to xef free cash flow every now and again you'll see it written like that now what is it it's a cash flow based figure it's an alternative to a profit number it's if you like a measure of performance based on cash flows not the kind of subjective estimates that go into building a profit and also count and it can be used two or three ways which I'll illustrate in just a moment as a kind of test as to whether the companies reported performance in profit terms is backed up by cash now what is this thing it comes from something called the cash flow statement and without turning this video into an academic exercise in what a cash flow statements are basically a cash flow statement is simply a list of the cash that the business has generated from trading usually known as operating cash flows this is a very simple summary so you've got operating cash flows that's cash received from customers cash paid to suppliers and so on you've got what could loosely be described as financing cash flows these are sort of headings that you see positive or negative and in there you've got interest received paid and you've got dividends received and paid so investing activities that generate or use up cash and then the third heading investing cash flows Papa tinges there so your cash flow for the year is the sum of the three and these these can be positive or negative this is investment money applied to buy fixed assets for example long-term assets the business skinny carry on using or even proceeds from the sale of fixed assets so cash flow statements buried behind the profit and aa scout on the balance sheet summarized in the business's cash flows now that would be the total cash in or if it's negative out over twelve months so if you like there's an alternative to profit nos account it tells a story of what the business has been up to for the last 12 months in cash flow terms how much cash was generated from our operations how much did we invest will receive from selling the crown jewels are long-term assets and how much base fee did we receive or pay in terms of interest and dividends bracketed together the sort of financing costs and returns associated with the business interest on debt and so on so where does free cash flow fit in well the answer is free cash flow unfortunately is something the directors don't publish normally if they choose to it's voluntary but it's not something that you'll just find thrown at you in the middle of set of accounts or highlighted convenient on the cover so it's something you have to put together yourself or it someone else puts it together for you an analyst for example know roughly what they've done so what are they trying to describe so free cash flow isn't total cash flow as a clue in the name there it's something else it represents the cash available to the business as a result of one years trading if you like that can be applied by the directors for almost any purpose it's like their discretionary cash flow what I mean by that it's normally the cash from operations and you hope that's positive I mean cracky of our day to day trading isn't generating cash than what are we doing miles we'll just shut up shop and do something else so it's normally the operating cash flow and then you make two or three deductions so you adjust it for interest paid and the reason for that is you can't not pay interest you can't say to the bank we're not paying this year's interest that's the kind of non discretionary cash flow you've got to pay it and there's an adjustment normally for investment in fixed assets to the extent that it maintains the business because again if you're running a business you can't choose not to replace fixed assets as they wear out otherwise you won't have a business so there is this concept of free cash flow is effectively the cash available to the directors from their operations after they've paid the stuff they have to pay right an example money week favorite for awhile Reckitt Benckiser the household goods firm cleaning products and so on let's take a quick look at the 2010 accounts and just ramble through and decide well what sort of free cash flow is Reckitt Benckiser generating now you may want not want to do this at home every single time on a set of accounts if you're lucky you may find the numbers been done for you either by your favorite website occasionally these things do pop up on financial websites or you may find an analyst write about it the point is as a rough guide to what free cash flow is let's take a quick look at Reckitt Benckiser massive firm well-known name been around for years and as I say they're into the kind of household domestic cleaning type day-to-day products that people are supposed to want in the good times the bad times after all in a recession you don't normally stop cleaning your toilet okay so Reckitt Benckiser let's take a look at a few numbers 2010 accounts if I was to rip open the cash flow statement what I find is operating cash flow that's the number I mentioned just now right at the top of this is all in millions two two one five okay that's all in for a million's all right in sterling millions that's operating cash flow that's the cash generated by the business in one year okay now what I need to add there is our interest so I mentioned we're going to include some of these cash flows that relate to financing and long term investing so you've got interest receivable 19 that's in millions you've got interest so that's on bangla composites and so on payable of 11 million sort of pipe and brackets you've got tax if you can't avoid paying tax much as I would like to six seven nine million this gives you an idea of how this numbers put together and you've got fixed asset purchases of 367 and then finally you've got some sale proceeds from selling fixed assets so that purchases sales just s the sales of 42 so that's positive now add that lot together so the operating cash flow the net interest received in this case tax paid can't do anything about that as a board and fixed asset disposals and acquisitions and you get down to around one to one nine million okay so that would be called the free cash flow and I'm aware I've traveled quite quickly through that but these numbers all available in the 2010 accounts and that basically gives you up a starting point if you like so the business generated in one year one to one nine of free cash flow right how is that useful okay as an investor that's just a number how is that useful here are two or three checks that I would recognize want to be doing right now as an investor on a company like Reckitt Benckiser mowers don't just trust the profit and loss account make sure you apply the free cash flow test and I would argue there are two or three good ones that you can do once you know what the free cash flow figure is okay so how am I going to use that number one option is this what analysts and investors quite like to do sometimes is first of all turn that into free cash flow per share so what you can do is you can take the annual free cash flow and divide by the average number of shares outstanding so I'll explain why I'm doing that in just a moment but here that's one to one nine thirty millions again divided by seven hundred and twenty four point two these numbers both from the accounts and that gives you one six eight point three p per Chet okay so free cash flow per share quite a common way of expressing free cash flow now while we've just done that because we can now test a number from the profit and loss account that gets a lot more coverage earnings per share now that is annual earnings from the profit and loss account but all those subjective adjustments and Clause things funny is going on in there divided by this number so basically we're testing the quality of earnings per share now per Reckitt Benckiser be basically if you're looking at the figures for earnings per share that's the one they do report you get two one six point five p per share now that one is available to front the accounts as EPS and the profit na Scouts are down the bottom so earnings per share two point one six point five per share at free cash flow per share one six eight point three so another way of looking at that is that is roughly eighty percent of that or another way of looking at it is to say good here's the reported earnings per share figure that goes into important things like the price earnings ratio if you're lost on earnings per share by the way do see my separate video on it there's another video also on price earnings ratio so that's all out there so I'm not going to cover that again here what we're doing is testing the quality of this number using free cash flow per share and we're saying yeah 2010 so we could look back over four or five years to make sure we're being consistent roughly free cash flow is eighty percent of earnings per share broadly speaking so there is good or certainly reasonable cash cover the earnings what you don't want to see is a massive gap all right that's going to start to make you suspicious if there's a massive gap so if this is huge and that is small suddenly you got to think to yourself well the company's reporting greater earnings per share but where's the cash what's happening why the difference it could be there are some dodgy accounting practices going on in here to boost earnings per share to look at investigated further satisfy yourselves what's going on or it could be the business is terrible at managing cash for example go back to what I said earlier on and imagine I'm growing a business I'm billing clients left right and center okay I'm giving them loads of credit I'm saying take as long as you like to pay me just give me a business all right what we happening is all the issuing invoices all over the place and booking profits but where's the cash could be taking months to collect perhaps I don't even get paid at all in some cases so I'm apparently growing my business the profit and also count is showing sales and earnings but where's the cash and that's the key point so if you get a big gap it's one of the kind of red flags like an alarm signal so that's one way you can use free cash flow here's another you can test the dividend so maybe what we do is we say okay is there a way but I can just check in cash flow terms that the business can afford the dividend that it wants to pay so another way you can use free cash flow is to take free cash flow per share and divide it by dividends per share and express that as a ratio now for 2010 that comes out to about 1.6 times okay for anyone not sure about dividends and doing this sort of calculation again I do have a separate video out there on dividend yields now what does this tell you free cash flow per share divided by dividends per share what you're looking for is a number of at least one and ideally a bit more than that because I mean two would be good what we're saying is as an investor dividends are a key part of your return from a business how many times could the directs have paid that out of annual free cash flow and you want the answer to be at least once otherwise you got to start to get seriously worried so here we're saying well yeah the directors could have paid the current dividend 1.6 times and cashflow that's a snapshot it's only one year and it gives you a feel for in essence how safe is the annual dividend so there's another use of free cash flow a check on the dividend so we got a check on the earnings bigger that was the first calculation we've got check on the dividend that's this calculation and then for bargain hunters there's another way you can use this and that's to look at something called a free cash flow yield you can ask yourself how cheap is a share now there are other ways you can ask this question hmm if a business offers a high dividend yield for example it might suggest that the share price is relatively low at the moment and you're getting a bargain so have a look at my video on dividend yields more on that there's the price earnings ratio that's a way of testing whether a share is cheaper expensive high price earnings ratios expensive low Peas possibly cheap and again I have another video on that whole topic but here is a way of testing it from a cash flow perspective and in the current climate I reckon this is a very useful backup measure of nothing else it's called the free cash flow yield and what it does a bit like a dividend yield except using cash flow what it tries to do is compare that number I just looked at the annual free cash flow which we agreed was a hundred and sixty eight point three P per share over the latest share price while it depends which day you look it up but when I took my reading that was three one nine five P and then it expresses the whole thing as a percentage that's what turns into a yield so one year's annual free cash flow over the current share price as a percentage gives you about five point three percent now what we're saying here is as someone looking for a bargain what you're looking for is evidence of decent cash flow generation compared to the share price actually this isn't spectacular okay what we're suggesting here is that the cash flow yield 5.3 percent not bad but that's not screaming bargain at me it's solid but it's not screaming bargain at me and that's partly because Reckitt Benckiser is viewed as a solid defensive stock in times of trouble so some people have already bought it nonetheless the free cash flow yield is a very useful way of just checking that a share represents good value in cash flow terms as a value investor the higher this number the better in many ways because it suggests that the current share price you're getting annual cash flows and relatively cheap or put another way the yield the return on your investment if you buy today's price in annual cash flow terms is a good one so what are we saying we're saying there's a number out there which the directors don't publish and it's very useful for investors especially in the current climate it's called free cash flow the problem with it is you have to do a bit of scrabbling around and not everyone wants to do that in the accounts to put it together but you'll also find the analysts refer to it and occasionally soda journalists so if you can face bolting the number together free cash flow you can then do three checks number one you can test earnings per share number two you can check whether the company can afford the dividend cash flow terms and number three you can also use it to eye up a potential bargain so as an investing number goes it's a well worth your time you

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Keywords: directors, investing, investment, figure, moneyweek, education, finance, tutorial

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Length: 22min 1sec (1321 seconds)

Published: Fri Aug 12 2011