The most important thing to look at to find a winning share

Fund managers explain to Cherry Reynard why this one thing helps them identify strong and enduring companies.

Cash matters. Anyone with a small business, or simply an unreliable friend, recognises that cash in the bank is worth more than cash owed or cash promised. Cash in the bank can be spent, invested or kept for a rainy day. For this reason, many fund managers place great emphasis on cash flow in guiding them to strong and enduring companies.

The amount of cash a company makes on its day-to-day business activities is an important measure of its quality. Nick Davis, European income fund manager at Polar Capital, says: "Cash conversion is a good way to gauge the quality of earnings – better companies tend to convert more of their accounting earnings into profit. Ultimately, investors care more about cash than accounting profit, as it is cash that is paid out as dividends, or reinvested in growth through capital expenditure or acquisitions. What’s more, good cash flow generation lets companies pay down debt more quickly after making investments."

Gold standard

These are all sound reasons to focus on cash flow, but Nick Payne, head of global emerging markets at Merian Global Investors, argues that it is a "gold standard" as a valuation tool for another important reason: He says: "It's very hard to fiddle without committing outright fraud. In contrast, earnings are quite subjective. For example, it is possible to vary the point at which a business chooses to recognise revenue or earnings. A company may provide a service, but when is that recognised in the accounts? Areas such as depreciation policy can also be quite subjective. They can either flatter earnings or make them look worse."

Corporate management teams are seldom above this type of manipulation. The term 'kitchen sinking' has become synonymous with a new chief executive's attempts to get every bit of bad news out into the market so that they have a low base from which to grow profits and revenues.

In the opposite direction, management teams know that the market is generally impressed with improving earnings per share (EPS) and that plenty of investors won’t look far beyond that. Get those right and a company's share price rises - at least in the short term.

Payne says many CEOs are still incentivised on EPS:

"Cash flow requires a bit more work to forecast. Analysts and CEOs have bought into the myth of EPS. It is easy to forecast and talk about. Many are remunerated on earnings per share."

That's one reason why management might seek to manipulate earnings per share and why they might not give an accurate picture of a company's prospects.

As well as being key to avoiding this type of manipulation, cash flow analysis is important to any appraisal of income. It is a far more useful tool in predicting the sustainability of dividends than, say, dividend yield. Davis says: "We prefer to use free cash flow yield, rather than dividend yield, to value companies. This is because high dividend yields are not a good indicator of value, as they may be unsustainable. It is important to distinguish between cash dividends and scrip dividends. Scrip dividends are dividends companies pay in the form of new shares. We are generally wary of consistent scrip dividend payers, as the practice dilutes earnings per share over time."

In contrast, he says, a company with surplus cash flow can pay dividends sustainably over time. Recently, a number of companies have paid dividends out of debt. At some point, these companies will run out of money or the dividend will have to be cut. An appraisal of cash flow would have revealed the problem.

Safer bet

Does this rule out certain companies as investments? Certainly, it is tough for early-stage firms to do well on the cash flow metric. The famed 'unicorns’' for example – privately held businesses worth more than $1 billion (£0.8 billion) – tend to raise shareholder equity and debt, and burn cash on the basis that it will ultimately be highly beneficial for the firm to be first to market.

It is possible to make money out of this sort of company, but such a play is highly likely to come with considerable risk. Companies with good cash flow tend to be safer bets.