Portfolios based on this new measure of stock value beat the market by 12.6 percent annually.
- Smart Money May 2004
Professional stock pickers use operational cash flow per share (OPS) as a lead indicator of companies' future share performance. I want to show how you can benefit from the results of an OPS analysis on your investment portfolio. I've been using this analysis tool for three years. It's easy to use and my three portfolios have shown excellent returns.
Unlike other predictors of stock performance, OPS is based on cash flows from a company's core business activities: you can't fake cash flow. In contrast, there is a long history of companies manipulating their accounting earnings, to the cost of investors. If a company is in trouble, OPS analysis will show this several quarters before it shows up in EPS (earnings per share). OPS analysis will show you when a stock is about to take off, well ahead of EPS.
ANAYSTS AND THE INVESTMENT COMMUNITY KNOW THAT EPS IS SOMETHING FROM THE PAST.
Here's why:
A company's operational cash flow (OPS) reflects how much money is generated and used during a specified period, after adjusting for non-cash items. It does this to best reflect a company's financial strength. A company can only survive in the long run if it can sustain healthy positive OPS per share. This will be attained only if the company's long-term cash inflow exceeds its long-term cash outflows.
A company must be able to generate sufficient operational cash inflow to cover its cash outflow in order to remain profitable. Positive OPS are indicative of a viable company whereas, negative OPS are an indication that a company may be in financial difficulty and its future is in jeopardy.
Earnings per Share (EPS) reflect a company's profit allocation per shareholder. The profit allocation is calculated using complex accounting rules, which can distort a company's operational results to present a rosier picture. OPS, on the other hand, eliminate non-cash items and reflect only cash transactions, which results in a more accurate picture of the company's results.
The chart below illustrates two companies whose results are measured by EPS. |
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Based on the EPS these companies were both rated as strong buys. However, if you look at these companies on a cash flow basis a very different picture emerges. |
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(The green bars are positive OPS, the red bars are negative OPS, the black bars are EPS.)
OPS analysis indicates Company A could be a favorable investment opportunity while Company B, is struggling to maintain its viability as it is not making money from its' core business.
When using an OPS analysis you need to examine quarterly trends to achieve a clear understanding of what is taking place.
The chart below illustrates EPS vs. OPS over an extended period of time. |
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The chart above shows a positive EPS over 15 quarters, while OPS has reflected negative cash flow over the same period. While the EPS indicator would encourage investors to buy this stock, the OPS indicator would caution investors not to purchase stock in this company. Shortly after reporting its highest EPS, Suprema filed for bankruptcy. Every company that has filed for bankruptcy has recorded its highest quarterly EPS prior to the filing for insolvency.
The Kmart graph below shows how solid a metric the OPS indicator is. |
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Kmart has always had positive OPS in the first quarter of each year. Suddenly, in Q1/02 Kmart shows negative quarterly OPS. This anomaly signaled that something was not right and perhaps it was time to sell the stock. |
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Kmart subsequently restated their financial statements.
Look at squares B and C in the chart above. It is important to note in both the original and the restated results, the OPS remained unchanged at -57 cents per share. Yet the EPS reflected a 700% decrease in its value from -6 cents to -48 cents per share.
This exemplifies how powerful a measure OPS is when analyzing a company's financial strength. Thus the OPS measure prompted an accurate signal to sell.
If you follow OPS as a measure of a company's financial health you would not be fooled by the Kmarts of the world.
The charts below will demonstrate how OPS analysis highlights buy and sell signals due to the appearance of anomalies. Kodak is an example of a positive anomaly. |
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The chart above reveals Eastman Kodak tends to experience negative OPS in Q1 of each year and then recovers in subsequent quarters. This trend signals a cyclical business model. This is not a cause for concern since it is a consistent pattern which many companies follow.
However, in Q1/02 Kodak suddenly experiences positive quarterly OPS. This is an indication that a positive change has occurred which directly impacts the companies' financial health. This should lead Kodak to achieve its best results in 5 years.
While Wall Street had sell and hold recommendations on this stock the OPS analysis lead to a buy signal.
In fact, Eastman Kodak in 2002 was one of the top 5 stocks to have owned. Their business model had indeed changed as they branched out into digital photography.
OPS Statistical Merits
A statistical OPS analysis was performed on 3,885 companies whose share price was above $6 in 1999. |
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If a company had 4 quarters of positive OPS it has the highest rating of 1. A year later 91.67 % of those companies were trading above $6.
Companies which had 4 quarters of negative OPS were given the lowest ranking, an 8. A year later 46.7% of those companies were above $6 while 53.3% had seen share price decreases. This is understandable as these companies do not yet have a viable business model.
The numbers 2 thru 7 are the different combinations of quarterly cash flows combined with the yearly cash flows being positive or negative.
Statistically, these are significant results. As the cash flow weakens, the probability of the share price decreasing, increases. |
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This graph for J Comm will be used to illustrate how these rankings at the bottom of the graph should be read:
Prior to Q2/01 JCOMM is a development stage company. Statistically, at this point in time the business model is risky as it is not yet self sustaining. This corresponds to the OPS ranking of an 8.
You would not buy this stock now, the risk is too great. There is a 53.3% chance this stock price will be down a year from now.
In Q3/01 JCOMM for the first time achieves positive quarterly OPS. The statistical risk associated with this company has changed from an 8 to a 7. There is now a 47.46% chance this stock price will be lower a year from now.
In Q4/01 there is a substantial leap in quarterly OPS. The leap is so significant JCOMM is now OPS positive on a trailing twelve month basis. This is very significant statistically speaking as there is only a 26.88 % chance this stock price will be lower a year from now.
Note the Earnings per Share for JCOMM have never yet been positive MEANING WALL STREET ANALYSITS IN ALL PROBABILITY ARE NOT COVERING THIS STOCK YET.
As OPS is a precursor to EPS we know the EPS will in all probability show up shortly, equating to Wall Street coverage. Q4/01 is the time to purchase JCOMM at $7.36 and today it is in the $40 range.
This analysis will highlight stocks ahead of Wall Street's radar because they are waiting for the EPS to show up whereas the OPS analysis has indicated the EPS is coming.
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