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Start by reading the statement of cash flows in the company’s annual report. See whether cash from operations has grown steadily throughout the past 10 years. Then you can go further. Warren Buffett has popularized the concept of owner earnings, or net income plus amortization and depreciation, minus normal capital expenditures. As portfolio manager Christopher Davis of Davis Selected Advisors puts it, “If you owned 100% of this business, how much cash would you have in your pocket at the end of the year?” Because it adjusts for accounting entries like amortization and depreciation that do not affect the company’s cash balances, owner earnings can be a better measure than reported net income. To fine-tune the definition of owner earnings, you should also subtract from reported net income:

any costs of granting stock options, which divert earnings away from existing shareholders into the hands of new inside owners

any “unusual,” “nonrecurring,” or “extraordinary” charges

any “income” from the company’s pension fund.

If owner earnings per share have grown at a steady average of at least 6% or 7% over the past 10 years, the company is a stable generator of cash, and its prospects for growth are good.

Next, look at the company’s capital structure. Turn to the balance sheet to see how much debt (including preferred stock) the company has; in general, long-term debt should be under 50% of total capital. In the footnotes to the financial statements, determine whether the long-term debt is fixed-rate (with constant interest payments) or variable (with payments that fluctuate, which could become costly if interest rates rise).

Look in the annual report for the exhibit or statement showing the “ratio of earnings to fixed charges.” That exhibit to Amazon.com’s 2002 annual report shows that Amazon’s earnings fell $145 million short of covering its interest costs. In the future, Amazon will either have to earn much more from its operations or find a way to borrow money at lower rates. Otherwise, the company could end up being owned not by its shareholders but by its bondholders, who can lay claim to Amazon’s assets if they have no other way of securing the interest payments they are owed. (To be fair, Amazon’s ratio of earnings to fixed charges was far healthier in 2002 than two years earlier, when earnings fell $1.1 billion short of covering debt payments.)

A few words on dividends and stock policy (for more, please see Chapter 19):

The burden of proof is on the company to show that you are better off if it does not pay a dividend. If the firm has consistently outperformed the competition in good markets and bad, the managers are clearly putting the cash to optimal use. If, however, business is faltering or the stock is underperforming its rivals, then the managers and directors are misusing the cash by refusing to pay a dividend.

Companies that repeatedly split their shares—and hype those splits in breathless press releases—treat their investors like dolts. Like Yogi Berra, who wanted his pizza cut into four slices because “I don’t think I can eat eight,” the shareholders who love stock splits miss the point. Two shares of a stock at $50 are not worth more than one share at $100. Managers who use splits to promote their stock are aiding and abetting the worst instincts of the investing public, and the intelligent investor will think twice before turning any money over to such condescending manipulators.10

Companies should buy back their shares when they are cheap—not when they are at or near record highs. Unfortunately, it recently has become all too common for companies to repurchase their stock when it is overpriced. There is no more cynical waste of a company’s cash—since the real purpose of that maneuver is to enable top executives to reap multimillion-dollar paydays by selling their own stock options in the name of “enhancing shareholder value.”

A substantial amount of anecdotal evidence, in fact, suggests