Understand Accounting To Be A Better Investor – Earnings Vs Free Cash Flow

One of the mantras I keep iterating on this site is that for you to be a successful investor, you need to understand accounting. I wrote about this in a post titled ‘Investors Need To Understand Accounting’. Reading and understanding an annual report will give you the clearest picture of a business and where it is headed. The accounts can show you whether a companies earnings are real or if they are just being magicked up. Conversely, knowing accounting and its intricate rules can help you understand a balance sheet and find hidden value in companies.

As I have mentioned before, for those that don’t understand accounting or don’t have the time to dig through the accounts of a company and really scrutinise it, index investing may be the way to go. But for those that truly want to make money from picking individual stocks, you need to have a good grasp of accounting. After all, accounting is the language of business and without it you would be like a dear in headlights?


Imperial Brands Dividend Sustainability

I recently got an email from a reader asking why I was so keen on Imperial Brands as an investment.

I have heavily been buying into Imperial Brands over the last year due to its attractive valuation and wonderful underlying business economics. I will not go into details here as I have written about it before.

The underlying question of the reader was as follows “ why are you so keen on Imperial Brands when its dividend is not covered by earnings. Am I missing something?”

Now this is a good question.

Go to any stock screen and it will show you that Imperial Brands earnings are 146.3p per share whilst dividends are 187.7p per share. This is a payout ratio of 128%! This surely looks unsustainable.

But digging into the accounts paints a different picture.

The headline earning per share figure does not portray the true economic reality. Earnings in this case are misleading due to past acquisition.

Looking at the acquisition history of Imperial Brands, it paid more than tangible book value for the companies it acquired. This is pretty standard practice when it comes to acquisitions.

Let’s look at an example to better understand this.

Say Company A has profitability of £10m and tangible assets on its balance sheet of £50m. The business would be worth much more than £50m to a buyer. Simply acquiring the business for £50m would deliver a 20% return on acquisition for the buyer. I am sure the owners of Company A wouldn’t want to let go of their business that cheaply.

Say Company B comes in and acquires the company for £120m. Company B would would add £50m of tangible assets to its balance sheet (the tangible book value of Company A) .

The £70m paid above the cost of those tangible assets would be recorded on the acquirer’s balance sheet as an intangible ‘goodwill’ asset. This goodwill would be amortised – depreciated – over several years or decades.

In the years after the acquisition, this amortisation of goodwill will be classed as an expense. But importantly it is a NON-CASH expense. This is because there is no cash outlay on subsequent years after the acquisition.

So whilst the amortisation of goodwill is an expense and reduces earnings, it has no effect on the company’s free cash flow.

Going back to Imperial Brands, due to past acquisitions, its earnings are reduced by approx £1 billion each year as a result of this amortisation. Without this non-cash amortisation expense, Imperial’s profits would be close to 70% higher!

That is why in the case of Imperial Brands, free cash flow is more important.

Free cash flow (FCF) is a measure of how much cash a business generates after accounting for capital expenditures such as buildings or equipment. Essentially, it is the the amount of cash generated by the company which is available to pay dividends, debt reduction, share buy backs, or acquisitions.

I personally want to own companies who produce sufficient free cash flow to fund the dividend. I also want to see free cash flow going year after year.

Looking at Imperial Brands, it has a Free Cash Flow per share figure of close to 300p. Its cash flow has been consistently high and far in excess of the dividend over recent history. This suggests that the company is generating more than enough cash to afford those increasing dividend payments.

So whilst dividends look unsustainable when looking at the earnings figure, Imperial produces more that enough free cash flow to cover and grow the dividend going forward.

This is why I underline the importance of understanding accounting principles. It helps you get a better grasp of a business. Just by knowing how amortisation is treated, you can see a company’s dividend sustainability in a different light. That is why I have been buying Imperial Brands over the past year. Whilst many may see it as a value trap, I see it as a valuable investment that will reward me handsomely over the coming years and decades.

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