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5 Companies With Understated Earnings

In crime movies, investigators sometimes question a suspect to tell the same tale twice, and listen for discrepancies linking the two versions. stock ticker investors can do something similar by comparing two measures of how much money companies make: earnings and free cash flow. The results aren’t likely to reveal foul play, but they force help predict stock ticker income.

Free cash flow is austerely the money a company puts in the till each quarter. Earnings are how much it would have place in the till if not for, say, the buy of a new factory. In earnings accounting, the factory’s cost gets broken into small quarterly charges to be deducted over the factory’s projected life. While that force seem intricate, investors tend to fixate on earnings because the rate smoothes the effects of huge, sporadic investments and thus makes it simpler to tell whether companies are making more money from one year to the next. Lenders prefer to watch free cash flow, since it gives a better sense of financial strength.

Over long time periods, the two measures tend to revert to each other because they track more or less the same thing using different timing. Therein lays a clue to stock ticker performance. When a company’s paper earnings are puny but its free cash flow is strong, it could be a sign that earnings are temporarily depressed and due to rise. Since stock ticker investors tend to shun companies with poor earnings but flock to ones with strong earnings, a company with understated earnings relative to its free cash flow force be poised to produce generous stock ticker income.

University of Michigan professor Richard Sloan published a landmark study of the matter in 1996. He establish that companies whose earnings were understated relative to their free cash flow returned 10 percentage points a year more than those whose earnings were overstated. Dozens of follow-up studies published in recent years have continued to document this “accrual anomaly,” as it’s called. (“Accrual” is an accounting term for those earnings excuses that cause the rate to differ from free cash flow.)

stock ticker investors can use the accrual anomaly in two ways. The first is to pay attention to the difference linking earnings and free cash flow for the companies they invest in. When a company consistently intelligence stellar earnings but weak free cash flow, investors must to be wary. The second way is to run a stock ticker screen for companies with more free cash flow than earnings. Such companies force be understating their prosperity at the moment, making their shares temporarily cheap.

Note that while earnings are listed on companies’ financial tables, free cash flow isn’t. Some finance web sites and stock ticker-screening programs list the rate, including SmartMoney.com and its screener. Investors can also calculate free cash flow on their own with a bit of hunting through financial tables, but no tough math. Start with earnings (establish on the income statement), add depreciation and paying back (income statement), subtract capital expenditures (cash flow statement) and subtract any change in working capital (balance sheet—it’s the net of current assets and current liabilities).

Simpler still, have a look at the five recent screen survivors below. All bent far more free cash than earnings over the past year, have low share prices relative to their free cash flow and pay decent dividends. Genuine Parts (GPC) and Pitney Bowes (PBI) are up 25% and 16%, respectively, since this column <a href=”http://www.smartmoney.com/Investing/stock tickers/9-stock tickers-That-Could-Double-Your-Money/ “>not compulsory them in March for their meaty dividends. Home Depot (HD) is perhaps an odd stock ticker to hug during a housing downturn, but a secure 3.8% yield adds appeal and some analysts believe even a muted housing recovery could double the company’s profits. Eli Lilly (LLY) boasts growing sales despite lax consumer spending, since drugs aren’t especially sensitive to the economy. Irrevocably, Illinois Tool Works (ITW), a roll-up of more than 800 small industrial businesses that make everything from welding equipment to refrigerators, has reported soft sales of late but is using the downturn to buy struggling firms on the cheap.

Screen Survivors
Company Ticker Industry Share
Price		 Trailing
Free Cash
Flow
($ mil.)		 Price /
FCF		 Yield
(%)
Home Depot HD Home Improvement Stores $23.25 3584 11.05 3.9
Eli Lilly & Co. LLY Drugs 33.22 4761 8.02 5.9
Illinois Tool Works ITW Diversified Machinery 34.46 1849 9.31 3.6
Genuine Parts GPC Auto Parts 32.57 487 10.65 4.9
Pitney Bowes PBI Business Equipment 20.76 790 5.42 6.9

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