Cash Is the King in Equity Valuation

Cash is the King

Realising importance of cash in stock valuation

By Shrinivas Tapadia

Setting the Premise

Stock Markets have witnessed a blood bath in the whole of 2008. With fears of economy also going into recession there seems no hope for Bulls to return to the market. The commonly used parameters like PE, EPS, Book Values, Price to Sales, EV, EVA, etc all seem to have failed investors. Even though on these counts all the blue chips have started to look a lot attractive still there are no takers for these stocks. Why?

The issue looks complex. But the answer is in traditional financial management. Simply put, in recessionary times investors are not going to be flattered by growth claims of a company. Because growth claims are going to land in a rough patch in terms of increased interest costs, input costs, and uncertainties in organic growth of a business. So what can attract them? Not just Indians but people all over the world seem to favour cash in such uncertain times. That’s also the key for selecting stocks for investing.

Importance of Cash:

The reality is that “cash is king” without cash, a company won’t last long. That may seem obviously simple; however there is a long list of companies that failed because cash was in too short supply.

How much cash a company can generate is one of the more important measures of its health. Yet, one hears more about P/E than almost any other metric on valuation, but it does not give you an accurate picture of a company’s ability to generate cash.

Cash flows are generally confused with net income of a company. Operating cash flow (OCF) is not the same thing as net income, but is derived from net income through a series of adjustments to working capital accounts on the balance sheet. This is an accountant’s way of saying that OCF details how cash flows into and out of a company. If more flows in than out, the flow is positive, if not, the flow is negative. Valuation will be affected when company is able to post a positive earning and still suffer from negative OCF. If a company is regularly spending more cash than it is taking it, something is obviously wrong.

This may obscure short-term problems such as burning cash, however sooner or later the company will have to face the basic issues that are causing the cash drain.

Some common sense approaches to stock analysis rely heavily on answering questions of the likes of:

1. What are the sources of the company’s cash flows?

John Burr Williams taught us that the value of any asset is the net present value of its discounted cash flows. Before the investor can even begin to value a business, he has to know what is generating the cash. It is important to be specific and avoid making assumptions.