Strategic Value Investing: Screening for Cash Flow and Value
Strategic value investing is about treating each investment as if you were buying the entire business. You need to ask the same questions you would ask if you were starting a business.
- Is this a business I want to be in and does it have good long-term prospects?
- Do I expect to get a return from this investment and when?
- Is the price I am paying attractive given the returns I expect to realize in the future?
There are many ways of evaluating expected future returns and determining price relative to value, as we discussed in “Selecting a Valuation Method to Determine a Stock’s Worth” (April 2014 AAII Journal). One common method is to evaluate the earnings or cash flow of the business. Now, earnings are nice, but you cannot pay your employees, suppliers, creditors and even yourself with earnings; payment requires cold hard cash. Ultimately to be of value to the owners, a company has to be able to generate positive cash flow. This is true whether you own a small business or are investing in shares of a large publicly traded company. There are other reasons for looking at cash flows, also. Earnings can be easily manipulated by management, and one method of evaluating the quality of a company’s earnings is to look at the relationship between cash flow and earnings. (For more about earnings manipulation, see the book “Asian Financial Analysis: Detecting Financial Irregularities,” by ChinHwee Tan and Thomas Robinson, John Wiley & Sons, 2014.)
In this article, we present a screen that uses custom cash flow variables designed for Stock Investor Pro (SI Pro), AAII’s fundamental stock screening and research database program, to identify companies with strong cash flow and selling at reasonable prices relative to cash flow.
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Stephen M. Horan is a managing director and co-leads educational activities at CFA Institute.
Thomas R. Robinson , CFA, provides leadership to CFA Institute’s largest region, the Americas, which includes Canada, the U.S., the Caribbean and Latin America.