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Free Cash Flow, The Right Way

Spend a little time reading about investing and valuing businesses, and it's inevitable that you will encounter the "golden rule" of business valuation: a business is worth the value of all future free cash flows, discounted to present value. This, of course, sounds simple, but actually involves much guesswork when it comes to determining things like expected growth in cash flows, as well as how much to discount them by. Even something as simple as determining what current free cash flow is can cause arguments amongst experienced investors! In this article, we will take a look at a few formulas used to determine current free cash flow and give a take on what the best is. But first, let's review why it is such an important concept.

By definition, free cash flow is the amount of cash generated by a business that is not needed to maintain operations. Since the purpose of any business is to generate cash for its owners (otherwise, why be in business?), you can see why free cash flow is really the most important statistic in investing. Note that we are talking about cash here, not reported earnings or net profit. The difference can be significant, as reported earnings often involve assumptions involving the value of intangible assets and certain expense items such as stock options. Cold hard cash, on the other hand, is as tangible as it gets and cannot be fudged by accountants. For more information, have a look at previous articles on understanding the income statement and understanding the cash flow statement. Free cash flow is the amount left over that can be used to provide value to shareholders in several ways: by paying a dividend, buying back shares, or re-investing in the business to grow revenues and profits.

The traditional, textbook method for calculating free cash flow is this:

Free Cash Flow = Net Income + Depreciation/Amortization - Capital Expenditures

This method is advocated in many older investing books. You start with net income, the approximation of profit earned in a given period. Depreciation and amortization are added back to it, as they are non-cash charges... the assets being depreciated have already been paid for as capital expenditures in a past period. It's conceivable that other non-cash charges, such as the writing off of goodwill or intangible assets would be added back here as well. Finally, capital expenditures are subtracted, as these represent the cost of maintaining or replacing the assets the business relies on to generate profits. The leftover amount is free cash flow.

As I mentioned, this is an older equation, from a time before the cash flow statement. The Federal Accounting Standards Board (FASB) only started requiring a cash flow statement for U.S. listed companies in 1987, and international standards followed in 1994. Before that, the income statement was the only thing available to use, and determining capital expenditures was truly a shot in the dark (requiring some serious digging into SEC filings to approximate). Now, however, we can get closer to what "true" free cash flow is, leading us to our next equation, which utilizes the information in the cash flow statement:

Free Cash Flow (FCF) = Net Cash from Operations - Capital Expenditures

Now we no longer have to guess as to what non-cash charges amount to or what capital expenditures are; companies are legally required to report them both to us! The net cash from operations is an actual value of how much cash came into the business in a period, and capital expenditures is an actual value of how much was spent in property and equipment. This equation gives us a real close value as to how much deployable cash is left over.

But this is still not a really accurate picture as to how much free cash a business is producing. Consider the following example. A new retail concept has been successful in a limited area and management has decided to take it national. Over many years, the company continues to open new stores, expanding into new markets and saturating ones it was already active in. After this growth period, the concept has exhausted it's potential, and new store openings die down. In fact, this scenario happens all the time, and depending on the stage of business evolution, using the above equation for free cash flow presents a very misleading picture. An example is Home Depot (HD):

Home Depot 2001 FCF = 2,796 - 3,558 = -762

Home Depot Current FCF = 5,359 - 2,451 = 2,908

In 2001, Home Depot was expanding rapidly, opening 172 new stores. In 2008/09, after 2 years of weak sales and a close to saturated market, Home Depot cut back significantly on new store activity, opening just 44 stores. We can see how this new store activity drastically affects capital expenditures, as the 2001 figure is over a billion dollars higher than the 2008/09 number. The resulting free cash flow number is equally skewed.

But wait a minute. Was that extra billion dollars needed to maintain operations in 2001, when Home Depot had over 1,000 fewer stores to maintain? Of course not! Those $1 billion in capital expenditures (and much of the rest) were, in fact, free cash flow that was invested to grow sales and profits, providing value to owners. So, to truly get a useful number for free cash flow, we should consider only maintenance capital expenditures, not growth capital expenditures.

Determining what is maintenance and what is growth in the capital expenditures figure is, unfortunately, pretty difficult. A few companies will separate them out, but it's not required and very rare. Fortunately, there is a line item that approximates what maintenance capital expenditures amount to: depreciation and amortization. This number is the amount by which current assets are being depleted, and it's reasonable to assume that the company will need to replace them at some point in the future. By using depreciation in place of capital expenditures in the Home Depot equations above, we get a free cash flow figure that makes a lot more sense:

"Sensible Free Cash Flow" (SFCF) = Net Cash From Operations - Depreciation/Amortization

Home Depot 2001 SFCF = 2,796 - 601 = 2,195

Home Depot Current SFCF = 5,359 - 1,906 = 3,453

Ah, now that makes more sense. Maintenance is much lower in 2001 with a store base just over 1,200 than it is currently with a store base close to 2,300. The free cash flow now better approximates the amount that Home Depot management had available to deploy, as well. Today, instead of re-investing in new stores, management has instead decided to save the cash and continue to pay dividends and buy back shares.

MagicDiligence always uses the "SFCF" equation when talking about free cash flow, and recommends it as the best approximation when doing company valuation.

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Disclosure: Steve owns no stocks referenced here.

Joel Greenblatt and MagicFormulaInvesting.com are not associated in any way with this website. Neither Mr. Greenblatt or MagicFormulaInvesting.com endorse this website's investment opinions, strategy, or products. Investment recommendations on this website are not chosen by Mr. Greenblatt, nor are they based on Mr. Greenblatt's proprietary investment model, and are not chosen by MagicFormulaInvesting.com. Magic Formula® is a registered trademark of MagicFormulaInvesting.com, which has no connection to this website. The information on this website is for informational purposes only and solely represents the views and opinions of the author. No warranty is provided or implied as to the accuracy, completeness, or timeliness of this information. This information may not be construed as investment advice of any kind, nor can it be relied upon as the basis for stock trades. Alexander Online Properties LLC, the proprietor of this website, is not responsible in any way for losses or damages resulting from the use of this information. Alexander Online Properties LLC is not a registered investment advisor. All logos are trademarked properties of their respective companies.

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Comments

Posted by njk1 on 2009-04-01 09:04:44

How about using Bruce Greenwald's approach for maintenance capex?: Multiply a 5-yr. avg. PPE/Sales ratio and multiply that number by the current reporting period's growth in sales (in dollars) for growth capex. Then subtract growth capex from total capex and you're left with maintenance capex.

A lot more work! Using deprecation/amortization expense would make things easier, unless one is a better measure than the other. Thoughts?

Posted by Steve on 2009-04-01 13:20:38

I wouldn't argue with Bruce, but his formula reasons that all capital provides the same incremental returns. This is clearly not true in the case of something like a commodity business where return on capital swings wildly based on underlying commodity prices. Even 5 years isn't enough to smooth those swings out.

Depreciation scales nicely with capital employed, even though it probably understates maintenance cap-ex by a little if you assume it costs somewhat more to replace an asset bought, say, 5 years ago. That's not always true though. Replacing a 5 year old computer might even be cheaper due to the way prices drop over time.

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