Free cash flow - OK I opened Pandora's box again, as the expression "free cash flow" has no specific FASB regulated definition - but I view it as the residue left over for the common shareholder after the enterprise has replenished any 'wasting' assets (PP&E, intellectual property, etc.) necessary to more or less sustain its productive capacity to generate cash flow. On a "per share" basis, in order to compare apples to apples, if a firm elects not to expense stock options (Pandora's box #2), then the cash used to purchase treasury shares in order to maintain a constant number of shares issued and outstanding must necessarily be deducted from free cash flow.
As far as links, the S&P "core earnings" calculation, as reported in posts a few days ago, may be a reasonable proxy for some of the adjustments required to get from reported earnings to free cash flow.
The basic problem with the Fed model I see Paul, is that it ignores the risk differential between common stocks and Treasury securities. Old Franco Modigliani and his sidekick Merton Miller would cringe at the omission. Would you pay the same for a guaranteed flow of cash payments as you would for an uncertain stream of GAAP earnings, the reinvestment decisions for which are made by corporate officers and boards beyond your control? Of course not, you'd pay less for the uncertain stream.
So the model fails by using the risk-free rate to capitalize S&P earnings - you need to use a risk-adjusted discount rate - Finance 101. A better proxy for a cap rate on S&P earnings is probably the average yield on 10-year BBB rated corporate bonds, which you'll see is around 203 bps higher than Treasuries.
Where the growth comes in is when the equity investor says, fine Mr. T-noteholder, you have your guaranteed stream of payments, but because I've carefully researched my gorillas and kings, my stream of cash flow residuals is going to steadily increase over time.
But if it doesn't, one is a fool to pay the same money to own a risky investment that *maybe* returns the same "true free cash flow" as a risk-free investment.
Edit: Here's a link for credit spreads over Treasuries:
bondsonline.com |
