Question: What is a good financial indicator to look at when investing in the stock of a company?
Asked at “Ask a Friend, Ask Efren” free service through www.personalfinance.ph, Facebook, and SMS.
Answer: According to Warren Buffett, an investor should be looking at owner earnings. But to better understand the financial indicator, let’s apply it first to household finances.
Consider a one-person household. In any given day, the household owner will need to spend on certain things like transportation to and from work, food consumed at home and at work, mobile phone load, income taxes, mandatory contributions to government sponsored plans, or overhead costs, if you will. By the end of the day, the household would have spent its money. But it will not exactly be a zero sum game because the household should ideally have money left in the bank.
Even if the savings in the bank get spent down to zero, the household will still have cash from income to help it get through another day, week, month and year on assumption that there is no problem with cash flow timing. In a sense, the difference between the household’s gross income and expenses is equivalent to its cash flow from operating that one person household. This is the same as net income plus depreciation, depletion and (non-debt) amortization charges for corporations. The household just does not need to account for the non-cash charges of depreciation, depletion and amortization.
But would not life be boring for that household if all it did was do the same thing over and over? That one-person household will probably want to add a little excitement by way of a vacation, eating out, and partying with friends. And for those wanting more conveniences in life, buying a car to beat the hassles of the daily commute will be ideal.
In addition, that household will eventually realize that life is meant to be shared. Therefore, plans of getting married and raising a family, sending children to school and buying a house enter the picture. And once the children have all grown up, the enjoyment of a long, healthy and still productive retirement would be top of mind. All of these can be had through delaying self-gratification. Particularly, the payout of cash (i.e. dividends to the household owners) that can be used to enjoy things is delayed and invested in earning assets.
The household would need to just work a little harder because of the party pooper called inflation.
By the same token, companies dream of growing.
How will the growth be funded, and inflation be offset? Similar to delaying self-gratification, a company may opt to retain earnings by minimizing cash dividends payment and reinvesting the cash in earning assets. The other way is by borrowing to buy the same earning assets.
Whether funding comes from a company’s own funds or from borrowings, such funding sources eventually need to be rewarded or repaid.
In both a household and company, the cash flow from operations minus investments in long-term earning assets is equivalent to owner earnings or what is also called free cash flow (FCF) from the asset perspective. FCF can be used to pay household owners/shareholders in the form of dividends and creditors in the form of principal.
Would it not be great if a household or company can still pay dividends to their owners to enjoy whichever way their heart desires even after paying for overhead and investing for the future (and of course paying debts)? That is personal and corporate finance at its finest.
Buffett is exactly looking for companies who can, amidst efforts to invest for the future and service debts, still pay dividends to its shareholders consistently and ideally on a growing basis.
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