Andrew and all -- please, let's try to keep it simple (or at least simpler), for the sake of anyone else who might be lurking here in the hope of picking up some useful -- and usable -- ideas.
As I noted in my previous post to Pirah, ever since 1989 companies have had to file consolidated staetements of cash flows, in accordance with strict & specific SEC rules. Those statements give a number for net cash from operations. I suggest amateur investors use that number, rather than try to calculate operating cash flow themselves.
Now, it is trickier to estimate FREE cash flow, because it does NOT correspond to the final number on the consolidated statement -- "cash and cash equivalents at the end of the year."
As Hackel & Livnat point out in their book on the subject ("Cash Flow and Security Analysis"), free cash flow has a lot of different names (surplus cash flow, excess cash flow, disposable cash flow -- perhaps also "cash earnings"), and there are numerous ways of calculating it. H&L note that free cash flow "is an intuitive concept; it focuses on the amount of cash that owners of a business can consume without reducing the value of the business." Hence the discrepancies.
For Standard & Poor's, for example, FCF is "pre-tax income minus capital spending." But most investors, according to H&L, also add in depreciation expense to get FCF. In another variant they cite, RJR Nabisco gets it by subtracting capital spending AND dividend payments on preferred stock from operating cash flow. And so on.
H&L themselves discuss two approaches to calculating FCF in detail. One is "direct"; the other, "indirect."
The "direct method" has the advantage of simplicity: deduct capital expenditures from reported or estimated (if you insist on estimating it yourself) operating cash flow. (Andrew: H&L also have a method for distinguishing non-discretionary capital spending from discretionary, which involves comparing the growth rate of cost of goods sold with the growth rate of capital expenditures.) Let me add that for amateur investors, this is the preferred method.
The "indirect method" is much more refined, and with many more advantages -- e.g., it figures in debt, which can eat up cash every bit as much as capital expenses can. However, it's hard to use, unless you are a certified cpa/financial analyst. H&L spend pages & pages describing and illustrating the indirect method, and anyone with a taste for complexity will probably benefit from looking into it.
Still another criterion they discuss is the so-called "recovery rate," the relationship between operating or free cash flows and total assets of the business.
Personally, I still prefer the "direct" method of calculating free cash flow, because it is easier for amateurs, and I am a confessed amateur. What you need to do, however, is to look at it in the context of other indicators you consider important in estimating a company's long-term viability. For example, since the "direct" method does not take debt into account, I screen for companies with BOTH good free cash flow AND low debt (short-term as well as long-term). It's simple to do, and gives me a rough, but I think reasonably reliable, idea about a firm's long-term value and viability.
Striving for absolute exactitude I think is a chimera, especially where long-term projections are concerned. And if you make the process too hard, most amateur investors, I think, will be discouraged from even trying.
joan |
