Share Sleuth: Why cash flow is better than profits

We all know a sudden rush to the head can make us look foolish. In the stockmarket, wagering large amounts of money on shares with very uncertain prospects may not only embarrass but also impoverish us.

Last month, I introduced the first of five criteria that combine to make a simple algorithm, a decision-making process, that tells me whether an investment is sensible or foolish. Some of the criteria use financial statistics. Others are more fuzzy, like the first: "How well do I understand the business?"

I give each criterion a score from zero to two, so the total score for a share will be between zero and 10. Typically, I consider shares with scores of seven or more worthy of investment, and shares with scores of five or less unworthy.

You cannot judge something you don't understand, so the first criterion is the starting point. The second is:

Does the firm generate excess returns?

If you tell me you earned £100 interest from savings in a particular account last year, I can't work out whether it was a good savings account and you received a high rate of interest, or whether you just had a lot of money in the account.

Likewise, a company's level of profit, £100 million, say, doesn't tell me whether it is a good company.

In both cases we need to know how much was invested to make the profit. At current interest rates, the savings account might be considered good even if it took a £10,000 deposit to earn the interest.

However, a £10 billion investment to earn £100 million profit (the same return, 1% annually) would be unacceptable for a company.

Why would a business take all the risk of renting premises, employing people, buying equipment, entering contracts, and holding stock, when it could put the money in a bank and earn the same return? To justify being in business, it must earn substantially more, which is what I mean by excess return.

The return the company makes on its investment, or capital, is a measure of profitability. For a long time I've used an 8% return on capital as sufficient to justify being in business.

I might forgive one bad year in 10, say, as long as the company was still generating cash, and I would prefer a business to earn more than 8% most years.

Profit is determined by accountants, but it's dangerous to assume a profitable company is a good one. Occasionally, companies are outright frauds.

Outstanding returns needed

More often profits are, for example, inflated by rules that allow accountants to defer costs to match revenues that should be earned in the future. If the revenues don't materialise, the company will have overstated profit.

To validate profitability, we can examine how much money has entered or left the firm's bank accounts - its cash flow.

I'll rarely give a share a score of two unless cash flow is relentlessly positive and average cash flow over many years is a high proportion of average profit (80% or more).

The past, as every investor should know, is no guarantee of the future. Knowing a company has been profitable isn't the same as knowing it will be.

That's where my final three criteria come into play, and I'll reveal them in coming months.

One company instantly comes to mind for its outstanding returns over many years. It's James Halstead, which makes vinyl flooring: the kind you tread on every day in hospitals, schools and offices.

I calculate average return on capital over the past 11 years has been almost 40%. It's never fallen below 34%.

James Halstead has on average earned 90% of profit in cash terms, and no less than 60% in the past 11 years.

How does the manufacturer of a mundane product earn such impressive returns? I've tried to unravel the Halstead conundrum before.

Portfolio members Alumasc, Finsbury Food and FW Thorpe have published annual reports recently.

 This article was originally published in our sister magazine Money Observer. Click here to subscribe.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.