Screens well'

I'm fed up of companies that screen well but don't stand scrutiny. The latest is Smith & Nephew, which looked like a shoe in, but, having painstakingly plucked the numbers from its last nine annual reports I feel, well, puzzled, and lacking in confidence about the quality of its earnings.

Skipping over shareholders' wealth, which has compounded lucratively over a decade at an average rate of 23% a year:

And the breakdown of return on equity, which shows net profit margins consistently around 16% and variable, but currently relatively low levels of indebtedness:

To the chart that's convinced me not to invest in Smith & Nephew for now. It shows return on equity, and the troublesome line is the thin blue one:

Free cash flow return on equity is the statistic that potentially undermines all the others because free cash flow is a check on net profit, and net profit is a key factor in all of the other statistics I've just mentioned and the earnings yield I use to gauge the company's valuation.

In any single year net profit and free cash flow can differ enormously since cash flow measures the movement of money into and out of the company's bank accounts but profit is adjusted so that revenues and costs fall in the periods over which they impact the company. For example the cost of expensive machinery is depreciated, or spread over the period in which the equipment will earn the company money. If it were not, and the entire cost was born in a single year, the company's results would give a false impression of its underlying performance.

Over a long period of time, free cash flow should be roughly equivalent to net profit. If it's not, then there may be something suspect about the accounting adjustments and its prudent to assume average free cash flow is a more accurate measure of the company's returns.

Do that and Smith & Nephew's earnings yield is 7% if we assume last year's free cashflow return on equity of 20% is typical, and just 4.5% using the median free cashflow return of the last ten years.

Suddenly Smith & Nephew looks less attractive. The earnings yield implied by its return on equity is closer to 11%.

The moral of this story is to check a company's free cash flow history before going to the trouble of profiling the company in more detail. I didn't think that was possible, but I've just noticed Sharlockholmes has added free cash flow per share to the ten year history of each company.

This can easily be compared to earnings per share to see if the former is consistently and significantly below the latter.

Free cash flow joins operating leases and pension deficits as factors that, by their omission, can fool my screens into ranking a company as cheaper, and stronger than it really is.