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Always go with the cash flow

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