Defining Earnings Capacity

Previous posts mentioned the term: Earnings Capacity, without a proper definition. In this post, I'll cover what I mean by “earnings capacity”.

One important initial point: The stock of a company without sufficient “earnings capacity” is in reality worthless. Trading in it is probably worse than gambling at a casino (and a lot less fun, I might add). Simply deciding whether a company has real “earnings capacity” or not is usually sufficient to eliminate most bad investments and focus on the good opportunities.

What I mean by Earnings Capacity is actually the free cash-flow that a business can generate over a significantly long period of time (again “significantly" requires definition, but maybe 10 years is a fair enough period? ).

Free cash-flow is defined as EBITDA - recurring working capital adjustments – debt repayments/interest - capex - taxes. So in essence Earnings Capacity = Long-term and Sustainable Free Cash-Flow.  Notice how Earnings Capacity has absolutely zero to do with the Accounting Earnings that most companies report and that are used by Wall Street to move stock prices.

Using the above definitions will generally help you avoid most terrible investments and locate some extraordinary investment opportunities. This is because very often most publicly-traded businesses that seemingly generate accounting earnings do not really generate any sustainable free cash-flow (or generate minimal free cash-flow) and hence are practically worthless for an outside passive investor. This is because these businesses either have extensive cap-ex needs, and/or they rely on continued financings to stay in business, implying that the business cannot support the debt and is at  best a ponzi scheme.

At the same time, many publicly traded companies that seemingly report huge losses are actually generating sustainable free cash and hence have some value as businesses and offer potentially great investment opportunities.

Looking at cash-flow and balance sheet statements over long periods of time can mostly help you separate the ponzi schemes from the legitimate concerns and the potentially profitable investment opportunities.

One last practical points:
Never Focus on Last Year or Next Year in the Stock Market: Focus on Sustainability and the Long-Term

If you want to make money with stocks you need to completely disregard the earnings for the past year and the earnings from the next year. What matters is the long-term free cash-flow generating capacity of the company and the sustainable cash-flow.

What happened last year or what will happen next year is only important if it reflects on the long-term and sustainable cash-flow and in most times it is misleading.

In fact, companies with good earnings in the past year will inevitably be overvalued while those with bad earnings and even major losses, could potentially be undervalued.