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Picture: 123RF
Picture: 123RF

The purpose of any for-profit business is just that, making a profit. Ultimately that profit reflects as cash, and for an investor how much of that cash is returned to us as a dividend. Warren Buffett once quipped that when reviewing a set of results the only two things you can really believe is the dividend and the page number.

With cash as king this is why the most popular valuation method of stocks is the discounted cash flow (DCF) model that looks to estimate the current value of a stock by predicting the expected future cash flow.

So when checking results, dividend is the go-to number I check first. I also want to see revenue and headline earnings per share (HEPS) growth. Ideally, the leverage in HEPS should be more than revenue and, even better, see the dividend up more than HEPS.

But there are many other ways we can keep an eye on the strength of a company’s cash flow because while dividends are great, they’re not all equal. Some high-growth stocks pay very little, or no, dividend, rather plowing the cash back into the business. Others have a healthy dividend policy of, say, paying 75% of HEPS while another may only pay, say, 35%. The risk is paying a high percentage of HEPS as a dividend means you may not be spending enough on growing the business.

One metric I really like is the free cash flow (FCF) per share. FCF is cash coming in, less operating expenses and capital expenditures. So it is before paying off debt, interest payments and tax. A higher FCF per share shows a company that is well positioned to spend on growth, manage debt and still pay dividends.

I will also overlay the FCF per share onto the share price graph and this often offers some real surprises. Many of the magnificent seven that have been driving markets actually show share prices largely keeping track with FCF per share. They may be overvalued, but no more than they were three years ago before the huge rally.

An old-fashioned way to track cash is to check how much they have. This is from the cash flow statement and tells you cash on hand at the period end. Did it grow? If not, why not? Not growing is fine as long as we can see where it went. Maybe into working capital, paying down debt or paying dividends. A weakening of cash on hand is usually a red flag, so you need to do more research.

What’s important is that even cash can be misleading. A poor strategic decision or not spending on growth can kill a business even if the cash looks good. Debt can also kill and hence keeping an eye on interest cover is important. Take earnings before interest and tax (EBIT) and divide by the annual interest expense. What’s the trend? Heading higher could be a red flag.

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