You guys are still on this CF/FCF thing! I looked back at when this started and I replied to a comment made by SB (#1993) ... March 03 @ 3:02PM ...
I think that a discussion of FCF is an incredibly important topic. It is ultimately what separates good companies from bad ones, profitable business models from cash drains, and winners from losers.
Beyond being able to calculate the figures ... classic FCF is After Tax Net Income plus Depreciation plus Amortization plus or minus changes in the Working Capital Accounts (i.e., Accounts Rec., Inventories, PrePaid Expenses, Accounts Payable, etc.) plus or minus Deferred Taxes (plus for Def. Tax Liability and minus for Def. Tax Asset) ... minus CapExpenditures.
There are many modifications to this formula, but the CapEx portion generates most of the options. In growing companies, the CapEx budget may be dedicated in large part to growth initiatives [This may obscure the more steady state cash flow]. This is true even in large, more mature companies. If you look at Disney's Annual, Eisner will actually break out Maintenance CapEx versus total CapEx (the numbers are something on the magnitude of $700mm versus $3.5Bn ... I do not have them committed to memory). Some will argue that maintenance CapEx [the "minimum" amount that it takes to operate the business at its current rate] is a better number to use. This is partly because this analysis lends itself particularly well to LBO's and takeovers and the like. The mythical "Financial Buyer" (FB) likes to look at businesses as bonds that generate cash to its owner ... if the FB can ratchet down the growth initiatives, he can generate more immediate cash flow ... and due to its immediacy, it is more "valuable." We can argue the merits of this analysis all day. If Disney only spent their Maintenance budget, wouldn't the brand suffer, and over time the business would have to turn down ... due to the lack of any major new attraction/movies/cruises ???
In the end, however, Depreciation and CapEx should move towards an equilibrium -- in effect, canceling each other out. This is more theoretical, but there are a bunch of good examples. When this happens, depending on the company's ability to manage the WC accounts (e.g., any increase in INV or AccRec ["uses of cash"] is offset by an increase in AccPay ["sources of cash"]), one gets closer to a situation where traditional EPS become more powerful -- as an indicator of the underlying health of the business. In fact, EPS are roughly the same as FCF per share.
Then, you can perform the analysis. If FCF/EPS is projected to be $2.20-$2.40 in FY2000 (June Fiscal), and the stock is at $28.5 ... what am I willing to pay for the stock? Well, it depends on how much you like the HDD business. Does SEG have the staying power necessary to compete in this business? Beyond the 8.1% FCF yield ($2.3 divided by $28.5 ... better than a bond ... but, with more "risk"), could their latest foray into the mobile market generate additional growth in the future from a FCF perspective? How about the "we have finally qualed at Dell U-4 drive?!?"? Doing the same math with the stock at $19 with a bunch more uncertainty looks like a lay-up in hindsight. Then, the math would have been ... can they generate $2.00 in FCF? If so, the FCF Yield is 10.5% ... looks like a junk bond. Now, how we move forward with this analysis with the VRTS acquisition of SEG Software is a touch more complicated ... the Profits/Losses will be treated on the Income Statement as a Equity Income Line ... it may be easier to back out the value of the VRTS shares from the Enterprise Value and just use the business that SEG has direct control over in the analysis ...
You can do the same math with more steady cash flow streams. I own RHD at $15. The company has been around since 1888. The top line growth is modest (~5%). The cash generation is not. In 1999, they will generate about $1.65 in FCF. That is an 11% FCF yield out of the box ... with minimal CapEx requirements, even in their most ambitious growth plans ... as one of two exclusive licensees in China (to produce the Yellow Pages there), the start-up expenses of the Joint Venture will be immaterial this year.
For me, I think this is an incredibly useful tool ... but it is just a tool. Understanding the business, the management's philosophy, and the competitive challenges are also vital. I love talking about it and learning about it. Sorry for my ramblings!
--Duker |
