Calculating Free Cash Flow

[jpware]

Out of curiosity, are there many people on this forum who calculate free cash flow manually, via annual reports? If so what is your methodology?

There are plenty of tutorials online, however when applying to an actual company's financials, my free cash flow calculation doesn't seem to match various online figures.

I'm struggling to match the free cash flow figures provided by either ASB securities research pdfs and also on Morning Star's website.

Personally, I like to calculate the numbers myself as I believe I'll understand the make up far better.

Any feedback or advice would be great.

Cheers.

[winner69]

Started a reply but all too complicated this time of the day

What are going to do with your FCF figure .... would help in responding

[jpware]

Hi Winner, thank you for your prompt response.

I'll be using the FCF figure for ratio analysis and also valuation. i.e EV/FCF, P/FCF to name a few.

Morning Star states on ASB securities research reports that they use the following formula for FCF "cash flow from operating activities - capital expenditure - dividends" however, I can't seem to get the FCF figure they have in the report. I don’t believe this to be the most accurate of calculations either.

The other formula I've been using is "cash flow from operating activities - Change in working capital - Capital expenditure - Dividends"

Change in working capital is "2011 CA - CL 2011" - "2012 CA - CL 2012" or for a more accurate calculation you could break CA and CL down and remove out discretionary choices that aren't an operating Asset or Liability. Even then I still can't get to the FCF figure they get.

If someone (Winner :)) has the time, could they kindly break down a FCF calculation from any New Zealand available annual report? I'll go through the report and ascertain where I'm going wrong.

Ultimately I want to set everything up in excel so it's nice and easy to calculate.

Thanks in advance.

[jpware]

I have just found a good thread by Sauce called Owner Earnings vs Free Cash Flow (http://www.sharetrader.co.nz/showthread.php?7877-Owner-Earnings-vs-Free-Cash-Flow). I'll have a good read over this in the mean time.

[Halebop]

I use Owner Earnings but as per the mentioned thread, cutting capex by maintenance and growth can be problematic. I don't think it's worth worrying about getting too scientific on method, there is a correlation between good cash flow and sharemarket performance and the reasons for this are intuitive. While markets can get this wrong for short periods (dot.com boom and bust comes to mind), the physics of good vs bad cashflow are certain over time.

[Sauce]

I have just found a good thread by Sauce called Owner Earnings vs Free Cash Flow (http://www.sharetrader.co.nz/showthread.php?7877-Owner-Earnings-vs-Free-Cash-Flow). I'll have a good read over this in the mean time.

Hi Jpware

Since that thread was started I think (hope?) a few things have started to sink in for me (and certainly I think Halebop's comment is spot on) so for what its worth (probably nothing!) here are updated thoughts on maintenance capex and capital intensity in general:

In trying to determine owner earnings, and specifically maintenance capex, precision is not important; it is better to simply grasp the general economics of the underlying assets and assure yourself that ongoing maintenance capex is going to be acceptable. As Halebop infers, if there is any kind of historical record, poor economics show up pretty obviously over time; in both cashflow and profitability measures.

The obvious and common examples of assets with poor economics are cars and airplanes which depreciate very quickly. Businesses like equipment-hire or car-hire, and airlines, are usually have to ensure the fleet is always modern and updated not to lose business, which means replacing their assets often. This means less future cash will be available for stakeholders. It's these type of businesses that require a lot of capital investment just to keep their head above water that are to be avoided (Qantas for example). I think most asset types can be researched and understood well enough over time to learn to make reasonable enough judgements on their long term economics, but not all as many assets are very complex or uncertain.

One thing that appears more obvious to me now, is that capital replacement needs are not always bad. Some replacement capital can generate a satisfactory return. For instance, renovating a house often means you can charge a new rent high enough that capital value is added over the cost; in the same way some businesses can generate more sales or higher prices when they update or replace existing assets. It's the rate of return generated on this new capital that is important - if the return is higher than alternative uses of the capital then value has been created, if not value is destroyed.

At the other end of the spectrum are the businesses that have almost no capital requirements that generate bucket loads of cash but have almost no opportunities for reinvestment. For instance, some service/people businesses can dominate local markets and generate enormous returns on original capital with very little in the way of physical assets that need replacing. But with almost no way of being successful in new locations and hence have no real use for new capital. They may still be great cash generators. In contrast, businesses that are capital intensive but generate high returns on existing and new capital (such as my favourite example Ryman Healthcare), are in my view, preferable to businesses that spit off a ton of cash, make stratospheric returns, but have limited use for new capital (Trademe for example).

This is all relevant to 'free cashflow' in the sense that it is only the cash that a business generates that owners can take out over time, discounted back to its present value at an appropriate rate of return, that matters to investors. So key questions become how much cash is being generated now and where is it going: Is it being paid to shareholders or reinvested as new capital? Is the asset base increasing or being replaced? What return can be expected from this reinvestment? Is it higher than cost? How long will these opportunities last?

Bets on future 'free cashflow' or 'owners earnings' are of course implicitly made by investors (as opposed to traders) when they decide to buy or hold stock, whether they realise it or not.

My guess is that investors in general, and I know I have definitely been guilty of this, use all sorts of financial ratios and measuring tools to assess investments, but in reality know much less than they realise about what is really important; the underlying assets.

PE, ROE, ROIC, CROIC, ROA, EV/EBITDA, Free Cashflow, Owner Earnings, Net Debt/Equity, DCF, and myriad others, are all useful tools but I now feel that debating the merits of one measure over another is somewhat specious, even though I have indulged in this myself.

Firstly, a good understanding of microeconomics makes all these tools useful. Secondly, I now feel I understand that you have to dig much deeper than simply measuring snapshot financials to truly understand a business. However, because the future is uncertain, precise calculations are likely to not only be wrong, but lead to overconfidence and other bias.

Regards,

Sauce

[percy]

Sauce.
On behalf of all of us,thank you for taking the time to fully explain such an important part of successful investing.

[jpware]

Thank you for your reply Sauce. You have provided a lot of valuable information.



PE, ROE, ROIC, CROIC, ROA, EV/EBITDA, Free Cashflow, Owner Earnings, Net Debt/Equity, DCF, and myriad others, are all useful tools but I now feel that debating the merits of one measure over another is somewhat specious, even though I have indulged in this myself.

Firstly, a good understanding of microeconomics makes all these tools useful. Secondly, I now feel I understand that you have to dig much deeper than simply measuring snapshot financials to truly understand a business. However, because the future is uncertain, precise calculations are likely to not only be wrong, but lead to overconfidence and other bias.

Regards,

Sauce

Generally I have been using ratios to provide me with a quick overview of a company. If I liked what I saw, this would prompt further investigation and I would go through and read the company’s most recent annual report and then several more. You are right though; investment decisions should not be based on ratios or valuations alone, but must include a thorough understanding of the microeconomics of the business.