This is going to be a long answer, so if you want a short answer, I suggest you skip to Section B, things to look for in the cash flow. I am interpreting the words “value a stock” in your question as understanding the quality of the company as against performing a DCF calculation.
Before I get into the answer, a short summary of what the cash flow statement contains so that we are all in the same page.
SECTION A - About the cash flow statement
A. Cash from operating activities - The section contains the cash the business made from operating activities. Ideally, if the company works on a pure cash basis, this number should be equal to PAT + Noncash expenses (like depreciation / amortisation) + Interest and other non-operating income/expense paid/ received. But because companies provide and take credit not all revenue and costs are received and paid in the same year. Hence adjustment is necessary to the operating cashflows for
a. net cash received or paid in current year pertaining to revenues and costs incurred in prior years and
b. net cash receivable or payable in future years pertaining to revenues and costs incurred in current year
This is the reason why there is an adjustment for change in working capital (which really gives the sum of a and b).
However, certain quirks you should be aware of
a. Where practical taxes on non-operating income / expense are not shown as cash from operating activities
b. US GAAP requires interest to be shown as cash from operating activities. Better to look at the actual cash flow statement to understand what exactly the business has done to interest costs and taxes saved on it.
It is therefore important to go through the cash flow statement to understand how the above items are classified so that you use the right metric to analyse the cash flows.
B. Cash used in investing activities - This is the cash used by the business is purchasing (or selling) fixed assets and other investments.
C. Cash from financing activities - This is the cash received/used by business in paying interest (net of receipts), dividends, taking and repaying loans or any equity / debt whatsoever.
Keeping the above context in mind and considering that you are a long term investor who wants to invest in companies that are expected to generate cash over the long term, this is how I would understand the cash flows.
SECTION B - At the outset it makes no sense to look at cash flows of one year. What is important is to look at cash flows of a few years. Ideally this few years should cover an economic cycle (recession – recovery - expansion – boom – contraction - recession) so that you are able assess how well the company is able to do across the economic cycle.
To analyse the cash flows, it is also important to understand the industry structure in which the business is operating in. Is it in the growing, mature or cyclical industry. (I have not considered dying businesses as I am not sure if they are worth investing in).
Things to look for in the cash flow
- Across the economic cycle, compare the sum of PAT + Non-cash expenses + non-operating expenses (Book Profit) with the sum of operating cash flows (Cash Profit) during this same period. This can be expressed as a ratio (BP / CP). In a mature business this should ideally be more than 1. In a growth business you can expect this to be less than 1. In a cyclical business this can be expected to be around 1. Reasoning – Mature businesses can expect to have a stable cash recovery and payment cycle. Growth businesses tend to give out comparatively more credit in its quest for growth. The ratio for cyclical business will be impacted by the severity of the economic cycle on its cash collection cycle.
- Another metric to look for is cash from operating activities - cash used in investing activities. This is also called as Free cash flows. Ideally a mature business, this should be consistently positive, for a growth business this may expected to be negative and for a cyclical business this may expected to be highly fluctuating but positive over an economic cycle.
- Finally, if we look at the cash from financing activities. Mature businesses may be expected to pay out more dividends and require little financing. Growth companies tend to pay out very little (or nothing) and may require a lot of financing. Cyclical companies tend to borrow a lot of cash in expansion and boom years and not much during recession and recovery periods.
A forecast of all 3 items will be very relevant for valuation of a stock.
Any inconsistency in your expectation needs to be looked into carefully. For example, a mature business having negative free cash flows is a warning sign. A growth business paying out dividends and then borrowing a lot of money is also a warning sign. However, a growth business not borrowing a lot of money is a positive signal.
In any case, you should remember that it is toughest to forecast cash flows of growth companies as there tend to be simply too many variables driving growth.
One should also exercise caution in completely relying on the cash flows of growth businesses, as you expect negative operating and free cash flows, coupled with high borrowings. Such a scenario could also indicate that the company is really not making any money and is really fudging its books of accounts to show high book profits.
Finally, cash flow analysis / valuation is only one of the indicators in fundamental analysis. I believe, understanding the industry structure, competitive landscape of the business, valuation (relative and absolute) at current prices, financial metrics especially ROCE / ROE, business and financial risks are other important factors that need to be considered before finally deciding on an investment.