An investor who does not have a finance background might believe that financial statement analysis is not his/her cup of tea. However, the reality is far from that. Investors can analyse a company’s quarterly and annual filings to gain critical insight on the fundamentals.
Within the financial statement, the cash flow statement is of utmost importance. It gives the actual inflow or outflow of cash from a business for a given period. Certain indicators from the financial statements can be used to identify quality dividend and growth stocks.
As a matter of fact, detailed company valuation is impossible without the construction of the cash flow statement. It’s the future cash flow of a business that’s discounted to present value to determine the extent of undervaluation or overvaluation of a stock.
Without getting into the more complex factors, let’s look at some of the very basic indicators that can help investors find value creators. Be it high growth stocks or dividend stocks.
Identifying Dividend Stocks From Cash Generated By Operations
If we look at the structure of the cash flow statement, the first key component is the company’s “cash generated by operations.” In simple words, this section of the cash flow gives the actual cash inflow from “core business operations” for the given period. Therefore, higher the cash flow from operations, the higher is the probability of the company being a quality dividend stock.
In addition, investors also need to look at the cash used in investing activities. This will help investors calculate the free cash flow. Free cash flow is simple the company’s operating cash flow minus the capital expenditure. A company with a robust free cash flow on a sustained basis is likely to deliver value through dividends and share buybacks.
I will provide more clarity with the help of an example. Looking at the second quarter of 2020 financial statement for Lockheed Martin (NYSE:LMT), the company reported operating cash flow of $4.5 billion for the first half of the year. For the same period, the capital expenditure was $636 million. This implies a free cash flow of nearly $3.9 billion.
As a matter of fact, LMT stock currently pays an annual dividend of $10.4 per share. The company has an attractive dividend yield of 2.72%.
Investors need to look at the trend in the last few years for the operating and free cash flows. This will give a good idea on the company’s dividend potential and dividend growth outlook.
A key conclusion is that cash flow per share and free cash flow per share matter more than earnings per share.
Identifying High Growth Stocks From Cash From Investing Activities
For an investor, there is no bigger sense of satisfaction than buying and holding a high-quality growth stock. The cash flow statement can help in identification of growth stocks.
Let’s try and understand this indicator with the help of an example. Tesla (NASDAQ:TSLA) stock has skyrocketed by 795% in the last one year. In fiscal year 2016, the company had reported negative OCF and a capital expenditure of $1.3 billion. In FY2017, the company negative OCF and a capital expenditure of $3.4 billion.
The key point here is that a high capital investment indicated future growth potential. The investments in the given years translated into revenue and cash flow growth in the subsequent years.
Therefore, investors need to identify companies where OCF might be negative, but capital expenditure is high. These are typically high-growth companies for the coming years.
An exception to the rule would be companies with an asset light business model. These companies do not have high capital investments, but can still be on a high-growth trajectory.
Finding Growth And Dividend Stocks From Financing Activities
Investors can also look at cash flow from financing activities to differentiate between growth and dividend stocks. I would also discuss one red flag that investors need to check from this section of the cash flow.
In simple words, the cash flow from financing activities provides the sources and uses of cash. What investors need to look at is the trend.
As an example, Apple (NASDAQ:AAPL) paid total dividends of $12.1 billion for the company’s financing year ending 2016. For FY2019, the total dividend paid was $14.1 billion. Further, for FY2016, the company repurchased shares worth $36.7 billion. For the last financial year, share repurchases were $69.7 billion.
Clearly, the company has been increasing dividends and aggressively pursuing share buyback. It’s a good stock to consider for the dividend portfolio.
The story is different for a growth stock. These companies do not pay dividend or repurchase shares. Instead, there is significant activity in terms of cash inflow to fund growth. As an example, Tesla has continuously issued debt and common stock in the last few years. This is an indication of a company in a growth phase.
However, investors need to be cautious. There can be companies that have continuously secured funds from debt or equity financing. But these companies have not been able to translate this financing into top-line, earnings and cash flow growth.
Aurora Cannabis (NYSE:ACB) is a good example. The company has issued debt and diluted equity in the last few years. The stock has however plunged as growth remains elusive and cash burn is high.
On the date of publication, Faisal Humayun did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.
Faisal Humayun is a senior research analyst with 12 years of industry experience in the field of credit research, equity research and financial modeling. Faisal has authored over 1,500 stock specific articles with focus on the technology, energy and commodities sector. As of this writing, Faisal Humayun did not hold a position in any of the aforementioned securities.