<Longer term, you have to make money. I know that you can cook the books, and many or most do to some extent. The question is how do you detect that. When evaluating a company that has prospects but no profits yet, the question is when they will have income. This is for the buy and hold investor who prefers not to use mutual funds or whatever.>
This is the issue which trips up most investors who are not familiar with financial statements and the difference between economic values and accounting values. Showing increasing earnings does not mean you are making money, it only means you are increasing accounting numbers. The trick that NSCP pulled last month is a perfect example of how a company can sell an asset carried below book value and change its reporting periods to produce a positive delta in accounting earnigns (breakeven) while actually producing a significant economic and operating loss. An increase in gross cash flow is a tell tale sign that money is being made, for it indicates that cash is being generated by operations yet it is not disguised by heavy reinvestment charcteristic of many high growth companies. This number has to be carefully massaged though, for some comapnies need a high investment and reinvestment rate to stay afloat.
A company that did not play the earnings game would actually make more money than a company that showed increasing quarter over quarter earnigns. Remember, the major investments for a growth company, marketing, M&A, and R&D, come before the net income to common line item. That means that you can minimize earnings by increasing investment towards the future, thereby:
- increasing current cash flow by sheilding funds from federal and state taxes
- increasing the likelihood of future revenues which would increase the valuation of the company,
- decrease the effect of future cash flow volatility by squirreling money away deferrals and reserves, thereby increasing cash flow by receiving interest/investment income on funds that have yet to be recognized as revenue therefore not currently taxable (MSFT and many insurers are masters at this) and,
- increase the potential of profitability by spreading expenses over a wider revenue base.
These are just a few of the characteristics associated with minimizing earnigns.
As for how to determine if a company is truly profitable, you reconcile net income, which produces a NOPAAT (net operating profit after adjustements for cash taxes) figure, that closely approximates gross cash flow. This figure is then divided by the amount of capital it took to generate it, which produces a return on invested capital. When comparing companies, the ROIC must then be adjsuted for risk by applying a capital charge to the invested capital, which adds a premium over the risk free rate to the operation in question.
RCM
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