Ultimately, a company's earnings or profits are the locomotive for its stock price. Earnings are what is left over after all the company's expenses are paid.
Remember that a company's earnings can be affected by once-off gains or losses, so it is important to strip these out and look at trends over an extended time period in order to assess underlying profitability.
Profits versus profitability
A company's profit figure is always a relative number. Just because one company earns more profits than another does not mean that it is a more profitable company.
When assessing a company's performance, you should always measure profits according to the capital employed in generating those profits.
That is why return on shareholders' equity (ROE) and return on capital employed (ROCE) are more meaningful performance indicators than the profit figure alone.
Such is the range of creative accounting treatments applied by companies, as well as different accounting practices in different countries, some analysts elect to downplay reported profit figures and focus instead on cashflow - the measure of money going into and coming out of the business. This, some contend, offers a more meaningful measure of the performance of the business.
If a company has a positive cashflow, it means that it has cash available to invest in the business and pay dividends. If it has negative cashflow, it needs to borrow money to keep the business going - a bit like running up an overdraft to maintain your standard of living.
Most company reports contain a cashflow statement in the annual report. Always be aware of the cashflow position of a company. It is possible, for example, under accounting conventions for a company to be profitable but have negative cashflow. Negative cashflow can kill even profitable companies and it certainly can kill start-ups.
Free cashflow can be calculated as cashflow minus dividend payments and capital expenditure (money the business uses to buy assets).
How Free cashflow is calculated
Free cashflow is calculated as:
|Free cashflow||= cashflow - dividend payment - capital expenditures|
|= 5.5m - 2m - 1m|
|= 2.5m pounds
Free cashflow is often expressed as free cashflow per share. To calculate free cashflow per share, simply divide free cashflow by the number of outstanding shares.
For the purposes of interpretation, free cashflow per share is expressed in terms of the stock price as the price/free cashflow per share (FCPS) ratio.
The price/FCPS ratio tells us about the market's expectations of the company's future financial flexibility. We can compare the price/free cashflow per share ratio of a company with those of other companies and with the industry averages. A company with a low price/FCPS relative to its sector may represent a buying opportunity.