Earnings vs Cashflows

Cash is King

In this post, we’ll explore a concept that looks simple on the surface but highly impactful in valuation: the difference between earnings and cashflows. Many investors confuse the two, but understanding this distinction is fundamental to value a business correctly.

A one dollar increase in earnings does not necessarily mean a one dollar increase in company’s cash balance. Let’s dive in.

What Are Earnings?

When a company sells a product or service, it records revenue but to arrive at profits, we need to subtract various costs and expenses.

Gross Profit

First, we need to calculate the Cost of Goods Sold (COGS). It includes only the direct costs required to produce the product. Subtracting COGS from revenue, will give us the Gross Profit.

Example — If a restaurant sells a food item, then the cost of ingredients used to make that item is the COGS.

Operating Profit

COGS didn’t include expenses like rent, utilities, salaries of employees, marketing, Depreciation, etc. These are operating expenses, which are not directly tied to making the product. Subtracting these expenses from Gross profit, we arrive at the Operating profit.

Net Profit

Taxes and Interest are coming into the picture now. Company needs to pay taxes on the operating profit but before that we need to subtract the interest payment if the company has any debt. Interest payments are tax deductible so it can be taken out from operating profit before paying taxes. The final result, after subtracting taxes and interest payments, is net profit — the bottom line.

Cash Flows:

As I said before earnings do not directly translate into cashflows. To understand why, we need to look at a few important building blocks before discussing cashflows.

1. Depreciation:

When a company purchases a large asset, such as machinery or a vehicle, it does not record the entire cost as expense in the year of purchase. Instead, it will spread the cost over a period of time (the asset’s useful life).

For example, if a company buys a truck for $100,000 and it estimates the useful life of the truck is 10 years then it will record $10,000 as depreciation expense each year for the next 10 years.

2. Capital Expenditures:

Capital Expenditures (CapEx), represents the money spent to acquire or upgrade long-term physical assets. In the example above, the $100,000 spent on buying the truck is a CapEX. This amount will be part of reinvestment a company make to increase or maintain its revenue.

The key caveat:

When the company buys the truck, $100,000 reduced from its cash immediately. However, the $10,000 depreciation expense it records every year is not an actual cash expense. So, CapEX affects actual cash but depreciation doesn’t. Look into the below table to understand it better.

3. Working Capital:

Working capital focuses on company’s short term financial health. It shows us whether a company can meet its short-term obligations and fund its day to day operations.

· Current Assets — Inventory, Account Receivable, etc. You can include cash holdings too if the company is using it for daily operations.

· Current Liabilities — Account Payable, Accrued expenses, etc. Interest bearing short term debt typically excluded here to avoid double counting, as it is already reflected in cost of capital (discount rate).

Free Cash Flow to Equity vs Free Cash Flow to Firm:

Before we move on to calculating cashflows from profit using the above mentioned components, we need to understand the two types of cash flows. A business raises capital from both equity holders and lenders.

Free Cash Flow to the Firm (FCFF)

FCFF represents the cash available to both equity and debt holders. Since net income is calculated after interest payments, we start from operating income when calculating FCFF.

*Depreciation is added back because it is a non-cash expense.

Free Cash Flow to Equity(FCFE)

FCFE represents the cash available to equity holders after debt payments. Below is how we calculating FCFE,

*New debt is added because it represents additional cash inflow to equity holders

Valuation:

To perform intrinsic valuation for a company, we first need to calculate the free cash flow to firm or equity for the current year. Next, we estimate the revenue growth and operating margin over a forecast period (commonly, 5 to 10 years).

Growth requires a reinvestment. Reinvestment is captured through:

(CapEx — Depreciation _ Change in Working Capital).

Using these inputs, we estimate FCFF or FCFE for each year in the forecast period, as well as for the terminal year (the period beyond explicit growth).

The projected cash flows are then discounted back to the present.

· FCFF is discounted using the weighted average cost of capital

· FCFE is discounted using the cost of equity

If FCFE is used, the present value of future cash flows represents the value of the equity directly. If FCFF is used, we subtract outstanding debt from the sum of the present value of the future cashflows to arrive at the value of equity.

If you revisit my posts on Nike and Netflix, these framework will help you better understand how these valuations performed.

Closing Thoughts

I hope this post provides a high level understanding of the difference between earnings and cashflows. There are several related topics — such as capitalizing operating leases, capitalizing R&D expenses, free cash flow distribution to stockholders, why companies have positive or negative free cash flows — that we’ll leave for another day.

I highly recommend reading this post of Professor Aswath Damodaran, to gain a deeper understanding of this topic. Much of my corporate finance and valuation knowledge comes from his books, posts and lectures, and I hope you find them useful as well.