A price-to-earnings (P/E) ratio is a common metric for measuring a company's valuation. It can be calculated by dividing a company's share price by its annual earnings per share -- or by dividing its market cap by annual net income.
While the metric can be a reliable data point for understanding part of the full company story, it should not be the only statistic used to contemplate the profitability of an investment. Using salesforce.com (CRM -1.45%) as an example, we will explore how using free cash flow and operating cash flow -- as well as P/E ratio -- gives us a more holistic approach to valuing a company.
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Why net income is not perfect
A talented CFO can make accounting adjustments for a company's balance sheet to create the impression that net income is better than it actually is. Deducting non-recurring expenses, stock-based compensation, or additional maintenance expenses are just a few of the common adjustments.
Most of the time these adjustments are entirely justified to depict a more accurate representation of how the company is set up for the future. It can also, however, lead to a true profit portrayal being slightly altered. This is why investors must dig deeper into a company's earnings reports for the full profit story.
As an example of how drastically net income and free cash flow can differ, let's look at Salesforce's first six months of 2020 when it posted a positive net income of $2.7 billion. Based on current earnings estimates for this year, the company trades for a P/E of 104. This lofty earnings multiple is understandable considering the company's consistently impressive expansion and its coinciding revenue growth.
When looking at Salesforce's free cash flow, however, the story begins to change. Over the same time period that the company posted impressive net income of $2.7 billion, it actually had negative $93 million in cash flow. How can this be?
Free cash flow is a more candid profit barometer than net income. While net income offers a smoother forecast of what financials will look like without some transitory costs, free cash includes all of those transitory costs in its calculation. Both offer a materially different take on a company's profit, and both are important.
Operating cash flow is a more encompassing metric
Operating cash flow is another important profit metric to study. Similarly to free cash flow, it does not allow for the accounting adjustments common with net income.
Unlike free cash flow, however, operating cash flow merely measures cash generation from day-to-day business on its own. Free cash includes operating cash flow in its calculation but also includes investing cash flow (i.e. buying a company or building a factory) as well as financing cash flow (i.e. stock sales and purchases or debt offerings).
What does this mean for operating cash flow as a profit barometer? While a company can issue debt or stock or even sell assets to make free cash flow look prettier, operating cash flow will remain unchanged.
For Salesforce, while the negative $93 million in free cash flow may seem discouraging, it also may be unfair to the company. Its operating cash flow was $2.3 billion while its investing cash flow was negative $3 billion due to costs associated with its acquisition of Tableau and an equity stake taken in Snowflake, among other things.
While free cash flow penalized Salesforce for one-time costs and net income offers leeway for tricky accounting adjustments, operating cash flow offers a more basic and pure indication of how profitable a business' current operations are.
So what?
Net income, free cash flow, and operating cash flow are all important profit barometers in evaluating an investment. Each metric taken in isolation leads to an investor missing key details that are vital to understanding a full company picture. Just like with our Salesforce example, when considering an equity stake in any company, you would be well served to consider all three data points.
