Heading into Part 6 of the evaluation process that I use to pick stocks and estimate what I believe their value to be I want to make sure that I am being clear about something. This is not the end all be all of the valuation process for myself and shouldn't be for anyone. This simply gives me all the information that I believe I need to make a decision, barring any significant news or developments. Again, barring any significant news or developments. Make sure you are staying up to date with the company's news before you make the purchase. There are some things that the numbers do not show.
Now without further ado, let's get to part 6, Cash Flow Analysis. As always here is the Hormel (HRL) evaluation that we have been working on.
The cash flow analysis portion of the evaluation is a relatively simply analysis that includes only 3 variables:
- Free Cash Flow (FCF)
- Net Operating Cash Flow/Sales Ratio
- Net Operating Cash Flow
From these variables I believe that I can get a good enough look at exactly what the cash flow of the company is doing and also how efficiently they are making it. Let's dig deeper.
Free Cash Flow
The year-over-year (YoY) number of FCF doesn't tell really give you a lot of in-depth information about the company. What is does do is simply let's you know whether the company has more or less cash to be able to spend freely than in the past. What is the good of this? Well for one thing if I see a decrease, as in the case of HRL, then I know that this is a red flag that I need to dig deeper on. Why did they decrease cash flow? Is it a good thing (such as paying off long term debt, acquisitions, buybacks, etc.) or is it a possible disaster (covering dividend with cash stores, higher interest rates, lower revenues, etc.)? This is a variable that allows me to quickly see how much more research is needed.
Net Operating Cash Flow/Sales Ratio
This variable may be new to some of you out there, but it is definitely one that I like to use a staple of evaluation. When I am looking at a companies revenue a YoY increase is a great thing to see as it means that they are selling more product. That being said this variable may be more important.
Net Operating Cash Flow divided by Total Sales ratio is presented as a percentage. This ratio tells you how efficiently a company can produce usable cash from their sales. For HRL you see that they currently have a ratio of just over 10%. This means that they make 10 cents to the dollar of every sale. Is that ratio good? Well it depends. Every industry will have a bit different look in terms of this ratio but what is most important for me is what this looks like YoY.
Let's look at HRL for a second. YoY Revenue increased, YoY EPS increased, YoY Net Income Increased, yet this ratio decreased by just over a quarter of a percent.
"If all the others increased then why should the decrease in this matter?"
That's a great question and the answer is easy. If you can get less cash from each dollar of goods sold then where did that extra money go? Is is something that is solvable, like inefficient new operating procedures, or is it something more, like excessive advertising trying to keep up with the competition, or something disastrous, cutting margins because a competitor is doing better than you at your own game?
These are questions that must be answered before you can start a long-term position with a company.
Net Operating Cash Flow
The last variable leads to this one, net operating cash flow. This is simply the amount of cash that the company produces with its actual business. In HRL's case this is how much money they make after operating expenses from selling all of their products. This is a very simplistic way to see just how much money a company is capable of producing each year without all of the potential accounting nonsense that can be added (or subtracted) in the magical bookkeeping slight of hand.
Here's a look at the net operating cash flow history for HRL:
As you can see HRL has had a bumpy ride in the past but has continued to grow its cash flow from operations over a ~20 year period. This can be stacked up against the other two variables we looked at to show the full picture.
So what does this chart (which didn't turn out great I admit) tell us? Well it tells us that while HRL has been cranking out gains in the revenue (2.8 billion in 1992 to 9.5 billion in 2016) its net operating to sales ratio has been rising at an even more rapid pace (4.6% in 1992 to 10.4% in 2016). This is a great sign to see. Not only has HRL been making more sales they actually have been increasing their profits along with it! Don't believe me? Take a look at this;
Leaving this section you may have more questions than answers about a company but that really is the point isn't it? There shouldn't be any quick decisions when starting a long-term position and if it is a quick decision then it probably has a higher probability of being a wrong decision.
As always feel free to leave any comments or suggestions below.