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Stocks With Possible "Hidden" Earnings

by John Bajkowski

Stocks With Possible

While most investors focus on earnings to measure company profitability and success, it can be insightful to see if cash flow generation corresponds with earnings. Earnings are calculated under the principles of accrual accounting, while cash flow measures the direct consumption and generation of cash. Earnings are influenced by factors such as depreciation and asset write-downs even if no cash was used or created in the process. The cash flow statement divides the uses and sources of cash into three primary segments: operating, investing, and financing cash flows. The operating segment measures cash generation and usage from day-to-day operations. The investing section captures investment and divesture in the long-term capital of the firm, while the financing segment examines how the company finances its capital (equity and debt) and how it rewards its shareholders through dividend payments.

Over the long term, cash flow and earnings should move in line with each other, so weak earnings and strong cash flow may be a signal that earnings are temporarily depressed and due for a recovery. This issue’s First Cut looks for firms with a record of positive free cash flow that is currently greater than earnings and that are trading with low price-to-free-cash-flow ratios. Free cash flow is calculated by taking cash flow from operations and subtracting capital expenditures and dividends paid.

The First Cut screen started with domestic, exchange-listed stocks with a minimum price of five dollars per share and market cap of at least $50 million. Financials were excluded. Stocks were required to have free cash flow greater than earnings for the most recent 12 months and latest fiscal year. The First Cut stocks also had positive free cash flow for each of the last five fiscal years and the most recent 12 months. As a screen for financial strength, the passing stocks have a ratio of total liabilities to assets below the norm for their industry. The relative strength index in the table reveals recent stock performance relative to the S&P 500. The 30 stocks with the lowest price-to-free-cash-flow-per-share ratio made the First Cut.

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John Bajkowski is president of AAII.


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