Screening on Dual Cash Flow

While earnings are still the primary metric used to judge company performance and measure the attractiveness of a company’s stock price, a growing wave of investors focus on cash. Cash levels help reveal the financial strength and resources of a company, while cash flow indicates the generation of new cash. Cash flow can reveal whether the company is generating or consuming cash in its normal operation, if it is investing for the future, and whether it is rewarding investors with dividends or seeking additional capital from the equity or debt markets. Cash flow analysis often provides advance notice that a company may be facing financial trouble even though earnings and sales are still looking strong.

We have examined a number of cash and cash flow calculations in the stock screens area of AAII.com (www.aaii.com/stkscrns/archive). “Screening for Cash Rich Firms” seeks out companies with high levels of net cash on hand relative to the company’s market value. The principle underlying this screen is that the cash can be the ultimate safety net for a firm. With a large cash hoard, a firm should be able to weather an economic storm, undertake expansion, or fund productivity improvements for future growth.

“Screening for Free Cash Flow” tries to identify firms that are priced attractively relative to their free cash flow, cash flow from operations less capital expenditures and dividend payments to shareholders.

Investors have turned toward cash flow because of its direct relationship to the firm’s ability to operate profitably. Earnings and earnings multiples dominate standard measures of firm performance and stock price valuation. However, slight accounting differences make it difficult to track earnings over time or to compare firms. Cash flow avoids many of these problems of comparability across firms and consistency over time.

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Dual Cash Flow

Ernst Institutional Research has taken traditional cash flow analysis one step further, developing a technique known as dual cash flow. The key to dual cash flow analysis is differentiating between the cash flow a company is generating from its operations and the changes in cash on the balance sheet. It is considered desirable for a company to show increasing cash flow from operations while cash flow from balance sheet changes declines. Dual cash flow helps measure the strength and quality of a firm’s cash flow.

While the primary goal of dual cash flow was to help judge cash flow and illustrate the trade-off between growth and liquidity, Harry Ernst and his long-time partner Jeffrey Fotta have also used dual cash flow to measure the attractiveness of individual stocks and the market as a whole. More recently, Fotta was named research director at Lindner Funds and became the co-manager of the Lindner Large-Cap fund, which is now employing quantitative screens such as the dual cash flow methodology to turn up potential stock picks for the fund. In this article, we examine the calculation of dual cash flow and develop a basic screen.

Operating Cash Flow

The dual cash flow method seeks out companies with increasing cash flow from operations but falling cash from balance sheet changes. It favors operating cash flow over cash on hand with the belief that operating cash flow acts as a clear indicator of company performance and profitability. The model views the build-up of excess cash itself as the growth of an unproductive asset. It also looks negatively on the use of cash to make up for declines in operating cash flows. Ernst and Fotta feel that the dual cash flow model can help provide an early signal of downturns or upturns in earnings.

The operating cash flow calculation within the dual cash flow model differs from traditional cash flow calculations. Notably, the model begins with the change in a company’s net worth (assets less liabilities) less changes in net property, plant, and equipment; long-term investments; and inventories (Table 1.) In other words, it’s the change in owner’s equity minus change in growth-producing assets. [If you find yourself getting lost in these financial terms, please check out our six-part collection of articles titled “Financial Statement Analysis” on reading and understanding financial statements and ratios. It is located within the investor pathways segment of AAII.com (www.aaii.com/pathways/archive).

Figure 1 is the quarterly financial statement printout for Intel Corp from AAII’s stock database and screening program Stock Investor Pro. The income statement and balance sheet data from the figure was used to construct the dual cash flow calculation in Table 1.

Two primary events lead to changes in net worth. The first is issuance or redemption of common stock. When a company issues common stock, the cash proceeds are credited to cash on the asset side of balance sheet, while an increase in net worth counterbalances the cash increase. Basically, the opposite occurs with a share buyback.

However, net income or earnings provides the more important and frequent change to net worth. Net income less dividends paid to common shareholders is added to retained earnings, which normally is the largest component of net worth. Basically, dual cash flow starts off its analysis by seeking out firms with growing net income. Furthermore, dual cash flow is normally examined as a percent of sales, much like profit margins. It is not enough for a firm to have increasing levels of earnings; more importantly, the figure should be increasing as percent of sales.

The second element of operating cash flow calculation subtracts the change in growth-producing assets from the change in net worth. Growth-producing assets consist of net property plant and equipment, inventory, and investments. Optimally, a firm should be increasing net income from its growth-producing assets without the need for additional heavy investment.

Balance Sheet Cash Flow

While the first element of dual cash flow looks at operating cash flow, the second element examines the use and creation of cash from the assets and liabilities on the balance sheet. Dual cash flow is constructed using the balance sheet and income statement, but differs from traditional cash flow statements in a number of ways.

While the statement of cash flows considers changes in accounts payable and accounts receivable as elements of operating cash flow, the dual cash flow model moves these elements into the balance sheet cash flow calculation. Balance sheet cash flow within the dual cash flow model is defined as the change in total liabilities less the change in accounts receivable. The result is normally expressed as a percent of sales.

Dual cash flow seeks companies that are borrowing less, paying back payables more quickly, and are able to lend out money to customers to support the purchase of goods through accounts receivable. The ideal firm is generating enough cash from operations with no need for additional cash from balance sheet maneuvers.

Dual cash flow is not a common calculation, but at least one Excel spreadsheet add-in can calculate the value. Spredgar Software (www.spredgar.com) offers a very useful and powerful tool for financial ratio analysis. The $250 Excel add-in can automatically retrieve and format quarterly and annual SEC Edgar filings into an Excel spreadsheet. The program provides a wide range of financial ratios, tables, and graphs analyzing profitability, financial leverage, liquidity, and valuation levels. A tabular report can automatically produce a dual cash flow report that tracks changes in dual cash flow components over time.

Constructing a Dual Cash Flow Screen

Ernst and Fotta feel that the best-situated companies show cash flow from operations rising from one quarter to the next, while cash flow from balance sheet maneuvers is on the decline. The reverse is true for the worst-situated companies.

We used Stock Investor Pro to calculate dual cash flow and look for firms with strong and increasing dual cash flow. The results of our screen are displayed in Table 2.

We constructed custom fields following the methodology laid out in Table 1. Stock Investor covers a stock universe of just over 9,600 securities. For our first screen, we excluded non-exchange-traded over-the-counter stocks. We did this to help ensure a minimum level of liquidity and access to current financial statement data. Requiring listing on the New York Stock Exchange, American Stock Exchange, and Nasdaq National and Small Cap market left us with 7,570 stocks.

For our next screen, we required positive cash flow from operation for each of the last two quarters. This quickly reduced the number of stocks from 7,570 to 465. We then required negative balance sheet cash flow for each of the last two quarters. This further reduced the number of passing companies to 244.

Our final screen required increasing dual cash flow over each of the last four quarters. The 38 companies passing the screen are listed in Table 2.

The operating and balance sheet cash flow for the most recent quarter are displayed along with the dual cash flow figures for each of the last four quarters. The list of passing companies covers a fairly diverse set of industries including technology, construction, healthcare, biotech, mining, hotel, restaurant services, and retail. Notably, no financial firms passed the screen, but this is probably due to their unique financial statement presentations.

Advance Micro Devices (AMD) passed the screen with dual cash flow at 50.8% of quarterly sales. Its operating cash flow was strong at 33.8% of sales, while its balance sheet flow of

–16.9% also contributed to the high dual cash flow calculation. AMD’s quarterly increases in dual cash flow growth were steady and impressive. By way of comparison, the profit margin is provided in the table. Profit margin is computed by dividing net income by sales and serves as a traditional counterpart to dual cash flow as a percent of sales. AMD’s figure of 19.6% is high compared to the semiconductor industry median of 8.5%. A number of the firms passing the screen have negative profit margins, indicating that these companies had negative net income over the last 12 months. The price-earnings ratio is given in the table as a traditional measure of stock price attractiveness. AMD ended the year near its 52-week low, and its price weakness is reflected in its relatively low 5.2 price-earnings ratio. The five-year annual earnings per share growth rate provides an indication of historical long-term earnings performance. The figure is calculated using fiscal years and does not reflect the strong sales and earnings performance since the end of the company’s fiscal year. AMD is expected to report positive earnings for its fiscal year ending in 2000 after four years of negative earnings. While not revealed in the table, the consensus earnings estimate averages out to a 18% annual growth rate in earnings over the next three to five years.

Conclusion

Cash flow analysis continues to grow in popularity as a measure of financial strength and operating performance. A strength of cash flow is that it reflects a company’s true operating performance. Dual cash flow extends the analysis by considering both operating cash flow and balance sheet cash flow, highlighting if a company is generating cash from its business or simply raising cash from the balance sheet—a move that usually only helps meet short-term liquidity needs.

Like all screens, our dual cash flow screen is only the first step in locating stocks to consider adding to one’s portfolio.