Monday Morning – Tip for investors: Follow the cash flow

If earnings drive stock prices, as academics insist, the key to the direction of the stock market is corporate earnings.

In particular, many investors – individual as well as institutional – compare year-to-year earnings for companies, industries and sectors in determining whether and where to invest.

Unfortunately, reported corporate earnings for the remainder of this year are likely to compare poorly with last year’s. In part, that’s because earnings were still being artificially inflated by many companies last year.

This year, many companies have adopted quite conservative accounting policies, so the comparisons look unfavorable. In addition, new rules allowing faster depreciation have affected the profit figures.

In fact, the pendulum may have swung too far in the direction of conservative from overly aggressive. Reported earnings may be understating the real economic earnings of companies.

profits still weak

This is suggested by data pulled together by Safian Investment Research Inc. in White Plains, N.Y. The Safian research shows that corporate profits before taxes as a percent of gross domestic product, while above their recent lows in late 2001, are still in the bottom third of their post-war range.

On an after-tax basis, profits look better. Here, they are above the post-war median percentage of GDP, but that’s because of declining tax rates, according to the research company.

The good news is that corporate profits before taxes in dollar terms are above the low they hit in late 2001, and they look particularly healthy for financial institutions. In addition, profit margins appear to have bounced off their low in 2001, which approximated the lows of previous recessions since the 1970s.

But the bad news is that companies appear to be understating their profits now, not just because of conservatism, but because they want to get all the bad news out of the way.

According to Ken Safian, the research firm’s president, one sign that companies are understating earnings is that they have reported weaker sales and earnings than analysts expected. “They are reporting adjustments that analysts should have seen coming,” he says.

“That’s a sign companies are putting a lot of costs into the third- and fourth-quarter results they otherwise might not have.” And, he says, they may be taking out of revenues things they otherwise might have included – such as sales they financed where repayment is now in some doubt.

If the market is expecting weak earnings, there’s less embarrassment if they’re a little weaker still, Mr. Safian adds.

One confirmation that many corporations could be understating their earnings is that cash flow is strong. The Safian data show that cash flow for all corporations has been relatively high, despite a small pullback in the first two quarters of 2002.

profit indicator

“Cash flow is more representative of profit trends, since the … new depreciation rules would have less of an impact on cash flow than other profit results,” according to the Safian report.

If the Safian interpretation of the cash flow figures is correct, companies are doing better than their earnings reports suggest. Ultimately, the companies will finish clearing the decks of the excesses of earlier years and the stronger cash flows will fall to the bottom line, where they will be more visible to investors.

That would be positive for the stock market and equity investors.

Of course, those money managers and investors who focus primarily on cash flow will be ahead of the game. They will have ignored the poor earnings reports, identified the strongest companies based on their cash flows, and taken positions ahead of the crowd.

Cash-flow analysis requires a few more steps than simply relying on reported or projected earnings, but often the signals it provides are clearer.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.