Wednesday, February 26, 2014

Earnings per share or free cash flow: What's the difference?

The quick and clean method of determining a dividend's safety is by the payout ratio.  The payout ratio is calculated by taking the dividends per share and dividing it by the earnings per share (EPS).


It's fairly easy and straight-forward and can be found on just about any financial website.  Of course there's all sorts of variations on the payout ratio as you can take the trailing twelve months payout ratio, forward twelve months payout ratio, a blend of the two...  The only thing that changes between those is what kind of dividends and earnings per share you're using, the calculation is the same.  But for some industries the traditional method just isn't all that useful.

Let's start with the difference between earnings per share and free cash flow per share.  Earnings are derived from the net income of a company.  Essentially you take the revenue of a company subtract certain expenses such as administrative, depreciation, interest expenses, cost of goods, taxes, and a whole host of other items.  That leaves you with the net income for that company and to get the earnings per share you just divide by the shares outstanding.  All earnings per share information and calculations can be found on a company's income statement.



Free cash flow on the other hand is a bit different.  You start with the net income from before but you have to add back some items that aren't cash expenses, such as depreciation and amortization.  This will give you the operating cash flow of a company and the free cash flow is calculated by subtracting the capital expenditures (Capex, "purchase of plant, property, equipment").

Let's run through an example to see what the difference is on earnings and free cash flow.  We'll assume a company needs to purchase a truck in order to deliver its goods.  The company has a net income of $20,000 each year and the truck costs $10,000.  To follow standard accounting practices the truck will be depreciated over a 4 year period, its assumed useful life, at 25% of the cost per year.

Year Net Income Free Cash Flow
1 $20,000 $10,000
2 $17,500 $20,000
3 $17,500 $20,000
4 $17,500 $20,000
5 $17,500 $20,000
Total $90,000 $90,000

So in year 1 the company had to spend $10,000 to purchase the truck.  You wouldn't know it from looking at the income statement but there it is showing up on the cash flow statement as capex.  So there's a $10,000 difference between the net income (earnings) and free cash flow for the company in year 1.  When year 2 rolls around net income will show a depreciation charge of 25% x $10,000 = $2,500 where as cash flow is no longer effected.  This will continue on until the depreciation period is up and then net income and free cash flow would be equal in this simple example.

For companies with large capital expenditures (think telecoms like AT&T and Verizon or utilities like PPL and Southern Company), depreciation charges can be very significant and lead to large differences in the earnings and free cash flow that a company generates.

Let's look at Verizon's financials from the last few years.  Keep in mind this isn't the end all be all of reading a financial statement, but I just want to highlight a few of the key differences between the balance sheet and income statement and their effect on earnings and cash flow.

Figure 1: Balance Sheet, i.e. earnings per share

Figure 2:  Cash flow

Depreciation and amortization charges are non-cash charges so they don't effect the cash flow year after year.  You'll notice a big difference between the earnings per share numbers and the free cash flow per share numbers.  In 2012 Verizon had only $0.31 per share in earnings but a huge $3.97 per share in free cash flow.  That's over a factor of 10 difference.  2011 wasn't on quite the same scale but it was still $0.85 in earnings but $4.77 in free cash flow.  That's a difference of over 5.5 times.  2010 saw 6.6 times higher free cash flow than earnings per share.

So how does this effect a dividend growth investor?  If you look at the traditional calculation of the payout ratio, dividends divided by earnings, it appears that Verizon's dividend is surely going to be cut.  So you might shy away from investing money in a stable company like Verizon.

Figure 3:  Payout ratios

The payout ratios were over 200% in both 2010 and 2011 and a whopping 664% in 2012.  That doesn't seem sustainable in the least bit.  But remember, depreciation charges are a drag on earnings over the expected useful life of the property, plant or equipment that was purchased, whereas it's a one time charge to the cash flow.

Recalculating the payout ratio as dividends divided by free cash flow paints a much different picture.  The FCF payout ratio has increased from 30% in 2010, to 41% in 2011, to 51% in 2012.  That's much different than the 203%, 234%, and 664% from the earnings per share payout ratio.

For companies that are very capital intensive, the earnings per share and free cash flow numbers can vary greatly.  You need to make sure that you're using the right payout ratio when analyzing the safety of a potential investment because the wrong one can lead to wildly different conclusions.

*Keep in mind that there are many other factors to consider before investing your hard earned money than just calculating the payout ratio of a company and that this is in no way an all-inclusive lesson in reading financial statements.

20 comments:

  1. That's a very useful post JC. It's also very relevant to dividend investors who are concerned about their future payouts
    -Bryan

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    1. Bryan,

      I'm glad you found the post helpful. It's a post that's been in my "rough draft" stage for over a year now and I finally got it written up. It's something that needed to be done because it's always good to know the difference and check the difference metrics.

      Thanks for stopping by!

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  2. Thanks PIP,

    I learned something today. :)

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    1. FFDividend,

      The More You Know!

      I'm glad you learned something about this. That's the great part about this DGI blogging community. I've never come across someone that won't help or teach you something if you have a question about it.

      Thanks for stopping by!

      Delete
  3. Really great post and useful info. I've always used both payout ratio and free cash flow yield vs yield when doing quick screens or deep analysis.

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    1. Zach,

      I think it's important to look at both because for some companies it can be a drastically different story. I didn't really check FCF when I first started investing because I just didn't really know about it but as I've learned I focus more on FCF than EPS.

      Thanks for stopping by!

      Delete
  4. Hi PIP,

    a great explanation!
    I have to put a link to this article, because it´s so great!
    In Germany EPS is very essential - but than all people say: No, cash flow is better...
    I don´t know.
    If you have no cashflow, you can´t give money/dividends to your shareholders!

    Best whishes
    D-S

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    Replies
    1. D-S,

      I'm glad you liked the article and thanks for the link.

      I like to check both but honestly I think cash flow is better. It's usually jumpier from year to year than EPS but I think it paints a truer picture. Like you said dividend are paid from cash so at the minimum you should be checking how the dividends are covered by cash.

      Thanks for stopping by!

      Delete
  5. I've always preferred free cash flow. EPS can be coaxed and massaged to look good, but cash is cash.

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    1. First Million,

      I didn't check cash flow when I first started investing because I honestly didn't know about it although I knew EPS can be massaged a bit more. I've started to lean more towards cash flow now though because cash is cash.

      Thanks for stopping by!

      Delete
  6. JC,
    Good explanation and VZ is the perfect example for this. As long as I've held it the payout ratio has been very high.
    -RBD

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    1. RBD,

      VZ and the other telco's and utilities are good examples of how fcf and eps can be very different. It's the companies that have huge capex to depreciate where you'll really notice it. For most companies they'll end up being about the same but it's still a good idea to check it.

      Thanks for stopping by!

      Delete
  7. Good explanation between the differences of EPS and free cash flow. I've always just focused on earnings with little regard to cash flow. I can see from your explanation how for companies with lots of capital expenditures/depreciating assets it may prove more useful to compare payout ratio to free cash flow in place of earnings.

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    1. Dan Mac,

      I also focused more on EPS when I first started investing. It was all so new to me that I hadn't even really come across FCF. But I've started to like FCF more than EPS but still check out both to see what the numbers look like.

      Thanks for stopping by!

      Delete
  8. I just read this again and a couple of things that I was unclear about became just that much more clearer. Thanks for the breakdown and writeup.

    cheers
    R2R

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    Replies
    1. R2R,

      Glad it helped the second read through. It'd be so much simpler for everyone if we only worked off one system because some companies earnings make sense, others book value, and others cash flow. But that's where we get the opportunity to look for mispricings.

      Thanks for stopping by!

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  9. What am I getting from earnings per share? After dividends are paid, what happens to the excess earnings per share?

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    1. The retained earnings can then be used for anything from expanding current business, expanding into new business, share buybacks, or just sitting in the the company's bank account.

      Delete
  10. Very well written article. I always seem to be learning from you. Much like when you first started out, I tend to pay more attention to EPS payout ratio but moving forward I will also be observing the FCF payout ratio for all businesses as well. Thanks for sharing.

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    1. MD,

      I much prefer to look at actual cold hard cash, although all 3 financial statements are vital to analyzing a company. The first one to master though is the cash flow statement. Glad to hear that you're learning something from me all the time. One of the big reasons I started this blog was to help out others so it's always great to get validation of that.

      Thanks for stopping by!

      Delete