Free Cash Flow: The Alternate Bottom Line

One of the themes that I continually emphasize with regards to fundamental analysis is an approach that treats net income as an ancillary, rather than primary, valuation metric. Instead, investors should use Free Cash Flow (FCF) as a starting point from which to assess a company.

Fundamentally, free cash flow is cash generated in excess of a firm's operating costs and capital expenditures (CapEx). Capital expenditures are investments a company makes in its property, plant and equipment. CapEx can be investment in new land, machinery etc., or substantial "repairs" such as putting a new roof on a building. Therefore, CapEx can simultaneously be thought of as investment necessary for growth of the business, and investment necessary for maintenance of the firm's assets. Free cash flow then, is a pure cash measurement that is indicative of the firm's ability to finance expansionary activities from internally generated cash. Conversely, negative free cash flow is potentially indicative of the need for future borrowing.

I prefer to take one additional step in the FCF calculation, and net out dividends. If a company regularly declares dividends, a real cash outlay will occur, and it will detract from the firm's ability to expand operations. You could argue that dividends are voluntary and can be reduced or eliminated; however, that would adversely affect the stock price as the market adjusted to the new, reduced stream of cash flows. The point is, be aware that there are varying definitions of free cash flow. An example of the FCF calculation for General Electric (GE), 2008 reported results follows:

Free Cash Flow = Operating Cash Flow - Capital Expenditures - Dividends
Free Cash Flow= ($48,601M - $16,010M - $12,408) = $20,183M

GE reported $17,410M for its 2008 net income, obviously a couple billion and change shy of its free cash flow generated for the year. The chart below looks at free cash flow v net income at GE and four other companies.
Despite the fact that Exxon (XOM) makes every other industrial corporation look like a mom & pop general store, a major observation to be taken from the chart is that FCF can be either greater, or less than, net income. I wouldn't lay out a bright line rule as to what the ratio between these two should ideally be; the ideal relationship will change depending upon the specific corporation. For instance, Wal-Mart (WMT) primary method of expansion is via construction of new stores, a cash outlay that is already netted out of the free cash flow equation. There might not even be any new ventures for which Wal-Mart would need to apply its free cash flow. A diversified conglomerate like General Electric however, must constantly venture into new business activities, thus necessitating ample free cash flow. The more important point is to look at the FCF trend over time, and within the context of the company's current status. Sphere: Related Content

Earnings Quality Analysis: Operating Cash Flow to Net Income

In my intro to fundamental analysis, I focused on discrediting the P/E ratio as a viable means of gauging the relative value of a stock. The premise behind my campaign of disparagement was that net income, or the "E", is influenced by so many non-cash adjustments as to render its predictive value useless. In general, you could say that my complaints revolve around the concept of "earnings quality" (or lack thereof in many circumstances). Although earnings can consist of both cash and non-cash adjustments, I think we can all agree that earnings based on an increase in a company's cash position are of a higher quality than those which are not. Luckily, there's a useful ratio we can deploy against the income statement to determine the quality of a firm's reported earnings: Operating Cash Flow (CFFO) to Net Income

As the name implies, the ratio is calculated by dividing a company's operating cash flow by it's net income. Operating cash flow is an item found on the Statement of Cash Flows, and is often labeled "Cash Flows Provided by Operating Activities", or "Cash From Operating Activities". Basically, business activities are all placed in one of three categories: Operating, Investing, and Financing. Operating activities are the actions a company takes pursuant to its normal, or core business activities. For instance, a PC company like Hewlett-Packard (HPQ) sells computers and printers as it's core operating activity; if HP sold a piece of land it owned, that cash increase would not appear as cash provided by operating activities. Once you've located your CFFO number, move over to the income statement and find net income. Make sure you use the after tax figure. Divide the two, and there you have your ratio.

Example: Hewlett-Packard (HPQ), 2008 fiscal year totals
Operating Cash Flow: $14,591M
Net Income: $8329M
CFFO to Net Income = $14591M / $8329M = 1.75

The following chart should put HP's 1.75 CFFO to Net Income ratio in perspective; it shows that same ratio for HP and 6 other large tech firms.When a company's CFFO to net income ratio rises above 1, it is indicative of a strong ability to fund it's activities through generation of operating cash flow. In other words, a higher ratio means that the firm's earnings are of a higher quality. Both Apple (AAPL) and Intel (INTC) were able to generate cash from operations that was nearly twice reported earnings. Dell (DELL) however, actually generated less cash from operations than it reported in net income. If I were an investor in Dell, I would probably keep an eye on this ratio in order to determine whether it was a chronic issue at the company. A CFFO to net income ratio which remains below 1 for an extended period of time could be an indication that the company will need to raise money to fund its operations.

Next installment: Free Cash Flow: The Alternate Bottom Line

*no positions Sphere: Related Content

Intro to Fundamental Analysis: What's Wrong With the P/E Ratio?

Far too often, the relative attractiveness of a stock is discussed in terms of its price-to-earnings ratio (P/E Ratio). This is an inherently flawed method for determining a stocks value; although the "P" portion of the equation is an objective fact at any given point in time, the "E" is exceedingly more suspect in nature. For those new to this, "P" is the price of the stock, and "E" represents earnings, or net income. To keep things simple, suppose you have a $10 stock, issued by Company X. Let's also say that Company X has earned 25 cents/share each quarter of the past year, and it projects earnings of 25 cents/share for each of the next four quarters. In this situation, Company X will earn $1/share this year. Therefore, at a share price of $10, the stock is trading at 10 times earnings, or a P/E Ratio of 10. Note: Some investors like to use a forward P/E ratio, which basically looks at the next four quarter's worth of estimated earnings to determine the "E". Other fans of the P/E use trailing earnings to calculate the denominator; in other words, the sum of the four most recently reported quarterly per share earnings. I purposefully fashioned my hypothetical Company X earnings report such that both the forward and trailing P/E ratios are 10. This doesn't happen in real life.

Now that everyone is hopefully up to speed, I can get into the real issue here: What's wrong with the P/E ratio? Well, as I said before, the problem is with the "E" or net income. In small business, net income - or more commonly "profit" - is simply the cash left over after you pay the bills. It gets a little more complicated with publicly traded corporations, all of which must adhere to Generally Accepted Accounting Principles (GAAP). Under GAAP, the quarterly income statements that all corporations must file include, and in some cases are dominated by, non-cash items. Let's say a company purchases a tractor for $10,000. Fast forward one year, and the company has accumulated say $900 worth of depreciation on the tractor. That $900 will be recorded as an expense on the income statement, reducing reported earnings despite there never being a $900 change in the company's cash position. As a contrasting example, consider a company that extends credit to a large customer on December 20th, selling $1M worth of software. The seller's assets will increase by $1M via a debit to accounts receivable, and revenue will increase by $1M. Assume that the terms of the sale on account dictate payment within 30 days. For the year ended December 31st, that company will report the $1M as revenue, although they probably won't have received the cash yet.

A further earnings distortion occurs based upon the quarterly price fluctuations of balance sheet assets the company lists as "marketable securities". Often times, a company will use surplus cash to invest in other company's stocks. The change in market value of these securities, whether or not they are actually sold for a profit (or loss), will be recorded as income (or loss) on the quarterly income statement. Obviously, these items are neither indicative of the company's operating performance, nor indicative of changes in its cash position.

Hopefully, by now all readers are appreciative of the reality that a corporation's reported net income is a fickle beast, and that it should not be trusted. Therefore, any ratio whose entire denominator consists only of "net income" should be viewed through a skeptical lens. Don't worry though, as this post is only the first part of the Fundamental Analysis series. Future posts will help investors develop a more holistic and accurate approach to stock analysis and valuation.

Next up in the series: Cash Flow From Operating Activities (CFFO) to Net Income Ratio Sphere: Related Content