Warren Buffett swears by this. Many great value investors espouse this. What I’m talking about is “owner’s earnings”. Owner’s earnings is similar to free cash flow. Free cashflow is simply capital expenditures deducted from cash generated from operations. This free cash flow is then be used to pump into the company’s business or given back to shareholder’s as dividends. The more the free cash flow generated and recycled into the business, the higher the value of the company.
Isn’t profits a much better figure to look at, you make ask. Not really. Profit-and-loss (P&L) statements include depreciation and is based on accrual. Revenues can be recorded even when the physical cash has not been received by the company yet. This is why there’s an accounts receivables column under the Balance Sheet. A company can show profits year after year but if its cash flow is negative, something is wrong and it may mean the company is trying to fool its investors. Cash flow statements are much harder to massage than the P&L statements.
Thus, always focus on the owner’s earnings rather than profits. And if a fundamentally strong company dishes out increasing owner’s earnings year after year, it might make sense to gobble up its shares!
SudhanP.com 