Cash Flow Restrictions Result in Lower Accruals
Though it may be a bit early in the article to hit you with this one, I want to start off by talking about it first because it is the one I consider particularly important. Usually, investors aren’t exactly interested in learning about advanced accounting techniques or diving into an income statement or balance sheet. Nevertheless, it’s the heart and soul of the investing process.
After all, a business is ultimately only worth the net present value of the discounted cash flows it can and will produce for its owners. In fact, when valuing a company or stock, most professional investors use a form of modified free cash flow rather than reported net income applicable to common. In my case, my preferred metric is something known as owner earnings.
A company that pays dividends has to physically come up with cash that investors can receive; cash that is mailed to them in paper check form, directly deposited into their checking or savings account or sent to their broker for deposit in their brokerage account.
As the saying goes, “you can’t fake cash”. Either the dividend shows up or it doesn’t. This has the effect of causing companies that devote money to dividends to have lower so-called accruals between free cash flow and net income.
In plain English, that means there are fewer meaningful adjustments in the accounting records of the corporation so the “quality of earnings” is higher in that the reported profits are almost in line with the conservatively calculated free cash flow. It is a well-established fact that, over longer periods of time, companies with lower accruals handily beat companies with higher accruals when measured by total return.