5 Companies With Understated Earnings

In crime movies, investigators sometimes ask a suspect to tell the same story twice, and listen for discrepancies between the two versions. Stock investors can do something similar by comparing two measures of how much money companies make: earnings and free cash flow. The results aren’t likely to uncover foul play, but they might help predict stock returns.

Free cash flow is simply the money a company puts in the till each quarter. Earnings are how much it would have put in the till if not for, say, the purchase of a new factory. In earnings accounting, the factory’s cost gets broken into small quarterly charges to be deducted over the factory’s projected life. While that might seem complicated, investors tend to fixate on earnings because the measure smoothes the effects of big, sporadic investments and thus makes it easier to tell whether companies are making more money from one year to the next. Lenders prefer to watch free cash flow, since it gives a better sense of financial strength.

Over long time periods, the two measures tend to revert to each other because they track more or less the same thing using different timing. Therein lays a clue to stock performance. When a company’s paper earnings are puny but its free cash flow is strong, it could be a sign that earnings are temporarily depressed and due to rise. Since stock investors tend to shun companies with poor earnings but flock to ones with strong earnings, a company with understated earnings relative to its free cash flow might be poised to produce generous stock returns.

University of Michigan professor Richard Sloan published a landmark study of the matter in 1996. He found that companies whose earnings were understated relative to their free cash flow returned 10 percentage points a year more than those whose earnings were overstated. Dozens of follow-up studies published in recent years have continued to document this “accrual anomaly,” as it’s called. (“Accrual” is an accounting term for those earnings excuses that cause the measure to differ from free cash flow.)

Stock investors can use the accrual anomaly in two ways. The first is to pay attention to the difference between earnings and free cash flow for the companies they invest in. When a company consistently reports stellar earnings but weak free cash flow, investors ought to be wary. The second way is to run a stock screen for companies with more free cash flow than earnings. Such companies might be understating their prosperity at the moment, making their shares temporarily cheap.

Note that while earnings are listed on companies’ financial tables, free cash flow isn’t. Some finance web sites and stock-screening programs list the measure, including SmartMoney.com and its screener. Investors can also calculate free cash flow on their own with a bit of hunting through financial tables, but no tricky math. Start with earnings (found on the income statement), add depreciation and amortization (income statement), subtract capital expenditures (cash flow statement) and subtract any change in working capital (balance sheet—it’s the net of current assets and current liabilities).

Easier still, have a look at the five recent screen survivors below. All produced far more free cash than earnings over the past year, have low share prices relative to their free cash flow and pay decent dividends. Genuine Parts (GPC) and Pitney Bowes (PBI) are up 25% and 16%, respectively, since this column recommended them in March for their meaty dividends. Home Depot (HD) is perhaps an odd stock to embrace during a housing downturn, but a secure 3.8% yield adds appeal and some analysts believe even a muted housing recovery could double the company’s profits. Eli Lilly (LLY) boasts growing sales despite lax consumer spending, since drugs aren’t especially sensitive to the economy. Finally, Illinois Tool Works (ITW), a roll-up of more than 800 small industrial businesses that make everything from welding equipment to refrigerators, has reported soft sales of late but is using the downturn to buy struggling firms on the cheap.