Cash Is King: Follow the Money Flow as Part of Your Stock Analysis

If you follow the earnings reports that public companies release each quarter, you might get the idea that earnings, earnings growth, and the price/earnings (P/E) ratio are the royalty among fundamental indicators.

And yet there’s that old saying: Cash is king. 

Although the quarterly earnings-per-share data grab most of the headlines each quarter, many analysts consider cash flow—a company’s cash inflows and outflows in a given period—to be the foundation of its financial health and a critical tool for deciding whether a stock might be worth a look. Some analysts claim that cash flow trumps dividend yields, earnings surprises, technical indicators, and even the venerable P/E ratio. 

Household Finance for Companies

Think about cash the way you think about your household finances. Most financial planning pros recommend keeping at least some of your holdings in cash—for two very good reasons: 

• Emergencies. A tree falls on your house. Junior breaks a bone and needs to go to the ER. You temporarily lose an income source. Let’s face it—life happens, and a cash cushion can give you that needed breathing room while you reassess.

• Opportunities. An investment property you’ve been eyeing suddenly becomes available. A market meltdown puts one of the stocks on your wish list into your “thumbs-up” range. You work for yourself, and you’ve been saving up for an expansion. The bottom line: When opportunity knocks, you like to be ready to answer.   

The same holds true for companies. Unexpected expenses sometimes strike—a product recall or a regulatory fine, for example. Companies also keep cash on hand for future growth—a merger or acquisition, a product expansion requiring a major capital upgrade, or other such opportunity.  

Companies that keep some dry powder on hand—and have historically been able to generate more—are often seen as the cream of the crop.  

Cash Flush

The corporate climate has been unusually cash-rich, with companies building up balances at a record pace, according to industry data. S&P Global Market Intelligence reported that, at the end of 2019, cash balances among companies in the S&P 500 (excluding financial, transportation, real estate, and utility companies) sat near record highs at $1.39 trillion, despite having spent record amounts on stock buybacks.

And who’s holding all this cash? The answer might not surprise you. Five of the top six are big technology and media companies we use every day: Microsoft (MSFT), Google parent Alphabet (GOOGL), Apple (AAPL), Facebook (FB), and Amazon (AMZN). The other one is a notorious cash-holder—Warren Buffett’s conglomerate Berkshire Hathaway (BRK.A). As of the end of 2019, these six firms alone held nearly $600 billion in cash.   

Cash on Hand vs. Cash Flow

Although holding large sums of cash can be a sign of strength, another (perhaps even more important) sign is a proven ability to make more. That’s cash flow.

And, importantly, cash flow is different from revenue. Revenue is often recognized on the income statement before any cash is received; an account receivable—money that’s owed or pledged to you—is considered revenue, for instance. The way many investors see it, if a business is generating consistent cash flow, it’s likely doing a lot of things right.  

“Cash flow is the most important indicator as you assess a company’s long-term prospects,” said Patrick O’Hare, chief market analyst at Briefing.com. “Companies that generate positive cash flow quarter after quarter are likely to be in a good position to deliver ongoing earnings growth and, if they choose, to increase dividends or repurchase shares.”

Cash flow can be a truer picture of a company’s status, making it different from earnings because it doesn’t have any accounting assumptions or accruals—revenue or expenses earned or incurred but not yet recorded.

In fact, cash flow is a hallmark of classical financial theory and stock analysis in what’s known as the discounted cash flow (DCF) model. Through DCF analysis, a stock is priced as the present value (i.e., discounted via the time value of money) of all future cash flows—not revenue, not earnings, but cash flow.  

Where to Look

You can find this data on a company’s cash flow statement, most often found in quarterly or annual earnings reports.

An easy place to start is a company’s investor relations page, which often has links to SEC filings (SEC.gov) or downloadable financial statements.

Additionally, the thinkorswim® platform from TD Ameritrade includes a page of fundamental research featuring corporate price-to-cash-flow ratios, per-share earnings, profit margins, and more (see figure 1).

Spotting Potential Red Flags

If a positive cash flow trend begins to decelerate or decline, it can be a warning signal for investors. Be wary of a company that is reporting increased earnings but decreased cash flow during the same period. 

And if a company isn’t producing enough cash flow to cover items such as capital expenditures, debt payments, or dividends, it could mean the company has to borrow to meet these payments.

A steady downward trend in cash from operations could point to weak management. It might also indicate a poor use of assets and resources.

The Bottom Line on Cash Holdings and Cash Flow

Many would agree that cold, hard cash rules. Certainly, it can be a valuable detail when it comes to looking at a company inside out. In short, cash flow and cash holdings can be—pardon the pun—valuable currency as you begin your stock search.