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Strategies & Market Trends : Free Cash Flow as Value Criterion -- Ignore unavailable to you. Want to Upgrade?

To: jbe who wrote (49)	10/30/1997 7:38:00 AM
From: Andrew	Read Replies (2) \| Respond to of 253

Joan, you said: "And since the working capital number is not a "per share" number, and since the number of shares out fluctuates from year to year, doesn't this present a problem (if only a minor one)?" When I use VL to calculate FCF, I use the raw numbers for net earnings and depreciation that they give, not the "cash flow" per share that they calculate for you. Then I multiply the cap. spending per share by the number of shares they show for that year. They don't give data for the changes in working capital. This seems to me to be getting into far more accounting nitty-gritty than most people would need. It's about changes in balance sheet numbers like accounts receivable, inventory and the like. Things like that I believe will eventually show up on the income statement under "sales", "cost of sales", etc. and will be counted in our analysis that way. As for "per share" numbers, earnings, D&A and cap. exp. are not fundamentally "per share" numbers either. You just take the total, and divide by the number of shares currently out, and presto chango - per share data. For example, a company that spends $30M on Cap. Exp., and has 60 million shares out, can be said to spend $0.50 per share. Increasing the share float through options definately dilutes the value of existing shares. Buybacks can help this, but still don't solve the problem, because it essentially means that the company buys it's own shares "high" and sells them to it's option holders "low". Then again it's hard to quantify the increase in future cash flow represented by valuable employees that the company encourages to stay by giving them options. Issuing stock through aquisitions can be non-dilutive if the company is smart about it. I look at it this way: if after the aquistion and increase in shares, the company is going to have the same or larger FCF per share, it was a good aquistion. Just like buying stocks - you want to pay less than what you're getting. That's why "pooling of interests" (ie. paid for in stock) aquisitions are so attractive to companies with "high" ratios. The higher your stock price, the fewer shares you have to issue - making it more likely that your aquistion will end up non-dilutive, and thus increase the value of your existing shares, rather than decrease it. This happened a lot in the 60's. Many P/E's were high, so a company could "fake" growth by using it's stock to purchase that of company's with low P/E's. By continuously doing this, their earnings per share would increase impressively, further "justifying" their high P/E. Of course, when the bear strolled into town, this little game went down the toilet. As ratios got crunched, the "conglomerates" could no longer make the attractive purchases as easily. So their growth slowed. And their P/E's fell further. And so on. Then they realized that while they did know a bit about running a military manufacturer, they had no idea about effectively managing a chemical business, let alone selling ladies lingerie. So they often started losing money. That's what Peter Lynch calls "diworsification". But a smart aquistion in the core business, purchased at a reasonable price, can increase FCF per share even if the number of shares increases. This is entirely analagous to our attempts to purchase parts of companies for long term capital appreciation. The less we pay for our FCF, the better we will do. I'm trying to put together a portfolio analysis method which measures how much FCF you "own" now - so that further purchases are only considered if their price gives you a chance to improve the "return on equity" of your portfolio. (essentially - only make non-dilutive purchases!) Warren Buffett does this at Berkshire Hathaway. Andrew

To: jbe who wrote (49)	10/30/1997 12:34:00 PM
From: Pirah Naman	Respond to of 253

jbe: > I'm still confused about your method of calculating free cash flow > using Value Line numbers. Sorry - I shall be more explicit here. > In my previous post, I asked you whether you simply subtract capital > spending per share from the cashflow per share. Your response was: >> <That would be the simple way to get the "cash earnings" >> described by GADR.> > Maybe. But that is also the simple, and the most commonly used, > method of getting "free cash flow." Your method is very different: >> <To get the actual free cash flow, all you'd have to do is add >> in the change in working capital from the previous year.> That last is not my method. That last was my understanding of how a strict calculation is done. I have not done this except a couple times to test and see how much of a change is made. In response #30 I give the numbers and the results for MLHR. In my spreadsheet I take the simple approach of cash flow - cap expenditures. You may be right about the SEC rules, I don't know, but even if you are somehow wrong I won't bother to "sophisticate" my approach. As Andrew pointed out, changes in working capital are no more impossible to incorporate than any other financial number. I don't bother simply because I consider all these projections to be "fuzzy." As I've said a couple times in this thread, any precision is illusory; you concurred when you said that it was a chimera. I use VL's numbers because they are the only outfit that details their projections, actually bothers to make projections in this form, and because they seem to be reasonably accurate at least in the short range. As they have spent time with the companies, their projections are bound to be better than any of my imaginings. PIrah