One of the basic models used today by virtually all investment advisors, writers, technicians and academicians is "projected future earnings." Forecasting is another word for predicting, the equivalent of betting. If you happen to be the house, betting is a sure thing: You don't have to be right, you just need enough gamblers. Investment banks know this. So does Warren Buffett, even though Buffett is not the house; he's simply someone who chooses not to bet.
No matter what Buffett has to say in his annual reports, the press is always going to ask him what he thinks will happen in the economy and the markets this year. As a consummate follower of Benjamin Graham, he resists.
There are no market forecasts in Graham-and-Doddsville because there is no way to know with any degree of certainty what will happen tomorrow. Forecasting represents an educated guess about a partial set of data to arrive at certain conclusions. It is inductive reasoning gone wild. It can be correct but usually isn't. Making investment decisions based on projected future earnings relies more on uncertainties than certainties.
Investors want to live off of their portfolios, not worry about them. Our interest as advisors should be in finding firms with sustainable dividends. That means our focus should be on owning good companies, not securities, for the long term.
Finding those companies begins with an eye toward free cash flow, which is notably different from net earnings. It's also different from gross earnings, which represent a company's sales of goods or services to an audience of buyers. Net earnings reflect the diminution of gross earnings by overhead-employees, offices, equipment, taxes, etc.-and are a general statement about the financial and management capabilities of the firm.
Free cash flow, on the other hand, represents the amount of capital available for distribution as cash to the shareholders of the company. It's arrived at by further reducing net income by charges for interest, depreciation, amortization, working capital and capital expenditures (capex). If any of these items are excessive, it will be reflected in the free cash flow. A company with attractive FCF will have a debt-to-equity ratio of less than 80%.
Still, free cash flow can be manipulated to some degree, even with fair and full disclosure. For example, maintenance capex, which under Generally Accepted Accounting Principles, or GAAP, does not have to be broken out from actual capex, can be irregular if it is used for isolated expenditures. The decision to incur such excess capital costs can be disruptive. It can also be viewed as a costly means to an end. (Some may regard integrated oil companies' constant capital expenditures for exploration and discovery to be a costly form of capex, and the opinion may be that returns are below the cost of capital.) The footnotes to balance sheets will typically reveal whether maintenance capex is a breakout item. Examples of excessive capex are more obvious since they likely reduce or remove the dividend distribution.
Thus, free cash flow is one of the most restrictive and truest ways to assess the success of a company. It's about knowing how much will remain after a company has covered all its overhead, accounting items and future capital needs, and it has nothing to do with the projections of future sales of automobiles, insurance, widgets or wombats. This is one of the core tenets of value investing.
Firms with solid free cash flow can use the capital for business development (capex), share buybacks, compensation or dividends.
Capex is often the first and best use of capital. Senior management should know how to grow the business. Some believe that share buybacks result in share price growth; I disagree. Buybacks usually involve a series of stock purchases at above-market prices. Using excess capital for compensation is also a losing game; just ask the folks in Washington.