Always go with the cash flow

THE LATEST NEWS FROM THE MOTLEY FOOL

Money makes the world go round. The more you have, the more you can potentially make. Just by leaving money in the building society, you are earning interest and therefore increasing your wealth. Debt, on the other hand, apart from the cheaper mortgage variety, will ultimately erode your wealth.

Individual companies work in a similar way to human beings. They are always looking to grow, to better themselves and, importantly, to increase shareholder value. After all, they are run by human beings who ought to benefit from a company's success. This can happen in the form of increased salaries, bonuses and possibly share options. Good companies make sure that top management's objectives are firmly aligned with those of their paymasters - the shareholders.

The first sentence of the 1998 annual reort from information technology company Misys says: "The Group's philosophy is based on enhancing shareholder value, measured by growth and stability of long-term cash flows." This succinctly encapsulates why quoted companies exist; and it should be at the forefront of every management's thinking.

There are many ways to value a company, but over the very long term a company is ultimately valued by the sum of its future cash flows. Shareholders investing money into any business expect to get that back, and more, and at the same time be suitably rewarded for the risk they undertook when investing. That may come in the form of dividends, capital appreciation or a combination of both.

One of the reasons shares in the engineering sector are so bombed out is that the companies do not generate much in the way of free cash flow. Free cash flow can be defined as money from operating activities, less capital expenditure and taxation. It is, in effect, the money left over after all essential payments have been made, and it can be used to increase shareholder value. Management may choose to fulfil this goal by paying out the money in dividends, making acquisitions, or buying back shares.

Engineering companies have much of their assets tied up in expensive plant and equipment. Think of the kit a company like British Steel needs to roll out all those sheets of metal. There are the factories, machines and lorries to name just a few things. This equipment is expensive to buy and maintain and needs replacing from time to time. This is money that cannot be used to develop the business, and therefore shareholder value, because it is needed just to keep the business running. To compound things even further, a company like British Steel operates in a very competitive environment and has little or no pricing power. It is little wonder, then, that the share price for this company has halved over the past four years.

On the other hand, a company like Misys has a much leaner operating model. It is essentially a service company, and supplies software products to the banking, insurance and healthcare markets. Once the company develops a piece of software, it can sell it to many different customers. The incremental cost of manufacturing is relatively small, and is usually outsourced to a specialist third party. Misys has very little money tied up in assets because it doesn't need expensive equipment in order to make its products. This allows it to throw off large amounts of free cashflow, which it can use to enhance shareholder value. In the past, Misys has done this by acquiring companies that complement its existing businesses.

When looking for investment opportunities Fools would do well to look at the company's cash generation abilities. Over the long term, this will ultimately drive shareholder returns.

n www.fool.co.uk

PROMOTED VIDEO
Arts and Entertainment
Standing the test of time: Michael J Fox and Christopher Lloyd in 'Back to the Future'
filmReview: A week late, Secret Cinema arrives as interactive screening goes Back to the Future
News
Chancellor George Osborne, along with the Prime Minister, have been 'complacently claiming the economy is now fixed', according to shadow Chancellor Ed Balls
i100... which is awkward, because he is their boss, after all
Travel
travel
Arts and Entertainment
Sydney and Melbourne are locked in a row over giant milk crates
artCultural relations between Sydney and Melbourne soured by row over milk crate art instillation
Arts and Entertainment
Adèle Exarchopoulos and Léa Seydoux play teeneage lovers in the French erotic drama 'Blue Is The Warmest Colour' - The survey found four times as many women admitting to same-sex experiences than 20 years ago
filmBlue Is The Warmest Colour, Bojack Horseman and Hobbit on the way
Arts and Entertainment
Preparations begin for Edinburgh Festival 2014
Edinburgh festivalAll the best shows to see at Edinburgh this year
News
ebookA unique anthology of reporting and analysis of a crucial period of history
News
i100
News
Kenny Ireland, pictured in 2010.
peopleBenidorm, actor was just 68
Environment
View from the Llanberis Track to the mountain lake Llyn
Du’r Arddu
environmentA large chunk of Mount Snowdon, in north Wales, is up for sale
Arts and Entertainment
arts + ents
News
Morrissey pictured in 2013
people
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Financial Analyst - Forecasting - Yorkshire

£300 - £350 per day: Orgtel: Financial Analyst, Forecasting, Halifax, Banking,...

Business Architect - Bristol - £500 per day

£500 per day: Orgtel: Business Architect - Banking - Bristol - £500 per day A...

Regulatory Reporting-MI-Bank-Cardiff-£300/day

£200 - £500 per day + competitive: Orgtel: I am currently working on a large p...

Trainee Recruitment Consultant - Birmingham - Real Staffing

£18000 - £23000 per annum + Commission: SThree: Real Staffing are currently lo...

Day In a Page

Dress the Gaza situation up all you like, but the truth hurts

Robert Fisk on Gaza conflict

Dress the situation up all you like, but the truth hurts
Save the tiger: Tiger, tiger burning less brightly as numbers plummet

Tiger, tiger burning less brightly

When William Blake wrote his famous poem there were probably more than 100,000 tigers in the wild. These days they probably number around 3,200
5 News's Andy Bell retraces his grandfather's steps on the First World War battlefields

In grandfather's footsteps

5 News's political editor Andy Bell only knows his grandfather from the compelling diary he kept during WWI. But when he returned to the killing fields where Edwin Vaughan suffered so much, his ancestor came to life
Lifestyle guru Martha Stewart reveals she has flying robot ... to take photos of her farm

Martha Stewart has flying robot

The lifestyle guru used the drone to get a bird's eye view her 153-acre farm in Bedford, New York
Former Labour minister Meg Hillier has demanded 'pootling lanes' for women cyclists

Do women cyclists need 'pootling lanes'?

Simon Usborne (who's more of a hurtler) explains why winning the space race is key to happy riding
A tale of two presidents: George W Bush downs his paintbrush to pen father’s life story

A tale of two presidents

George W Bush downs his paintbrush to pen father’s life story
Restaurateur Mitch Tonks has given the Great Western Pullman dining car a makeover

The dining car makes a comeback

Restaurateur Mitch Tonks has given the Great Western Pullman dining car a makeover
Gallery rage: How are institutions tackling the discomfort of overcrowding this summer?

Gallery rage

How are institutions tackling the discomfort of overcrowding this summer?
Louis van Gaal has £500,000 video surveillance system installed to monitor Manchester United players

Eye on the prize

Louis van Gaal has £500,000 video surveillance system installed to monitor Manchester United players
Women's rugby: Tamara Taylor adds fuel to the ire in quest to land World Cup

Women's rugby

Tamara Taylor adds fuel to the ire in quest to land World Cup
Save the tiger: The day America’s love of backyard tigers led to a horrific bloodbath

The day America’s love of backyard tigers led to a horrific bloodbath

With only six per cent of the US population of these amazing big cats held in zoos, the Zanesville incident in 2011 was inevitable
Samuel Beckett's biographer reveals secrets of the writer's time as a French Resistance spy

How Samuel Beckett became a French Resistance spy

As this year's Samuel Beckett festival opens in Enniskillen, James Knowlson, recalls how the Irish writer risked his life for liberty and narrowly escaped capture by the Gestapo
We will remember them: relatives still honour those who fought in the Great War

We will remember them

Relatives still honour those who fought in the Great War
Star Wars Episode VII is being shot on film - and now Kodak is launching a last-ditch bid to keep celluloid alive

Kodak's last-ditch bid to keep celluloid alive

Director J J Abrams and a few digital refuseniks shoot movies on film. Simon Usborne wonders what the fuss is about
Once stilted and melodramatic, Hollywood is giving acting in video games a makeover

Acting in video games gets a makeover

David Crookes meets two of the genre's most popular voices