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

To: jbe who wrote (91)	11/2/1997 11:38:00 AM
From: Andrew	Respond to of 253

Joan, sorry about that... Ok, I'm going to explain my limited understanding of the cash flow statement. I'll apologize in advance if this is old news, but I need to do it in order to explain why I do it this way. First, I THINK we generally all agree that FCF = net earnings + D&A - Cap. Exp. in it's basic form. A lot of people do valuations purely on cash flow, which is basically net earnings + D&A(since D&A are not really "cash costs"). Us FCF freaks like to frantically point out "You can't add depreciation back unless you subtract Cap. Exp. also!" So FCF also = "cash flow" - Cap. Exp. So you're asking why do I add net earnings and D&A to get "cash flow" instead of just taking the "net operating cash flow" off the cash flow statement. The cash flow statement is the link between the income statement and the balance sheet. The income statement alone does not explain quarter-to-quarter or year-to-year changes in the balance sheet, like the cash balance for instance. Part of this is because of several "non-cash" charges to earnings on the income statement. The cash flow statement kind of adds back the non-cash charges so that you can see how much cash really came in. It also shows where cash went out for things like capital expenditures and other investments. So it explains why the balance sheet changed. Several of the non-cash charges that are added back in to get the "net operating cash flow" total are a little ambiguous to interpret. There's deferred taxes. And changes in inventory and accounts receivable etc. There's "Provision for inventory allowances" (!?) There's adjustments because of merger accounting. "Tax benefits from employee stock plans". Many of these things just aren't as obvious and predictable as D&A, so I don't understand well enough the implications of including them. Therefore I feel it's conservative to ignore them, and work with a lower number. Of course, often the other numbers are much smaller than D&A, so it doesn't matter much anyway. Until my accounting knowledge improves, I'll play it safe for now. If you can explain some of these other factors for me, and why I should count them, by all means I'd appreciate it! As for specific stocks, I'd humbly like to nominate Intel for the panel to pin a valuation on (since I think it's getting close to my "buy zone"). One thing in particular I'd like to consider is the effect of the cash they have to fork over to buy their own stock to cancel out dilution due to stock options. This is essentially an expense that companies are allowed to "hide" from the income statement, hence exaggerating net earnings. With intel and many others, this expense is becoming VERY significant. I'd like to propose for this purpose a new calculus for consideration: FCF = Net Earnings + D&A - Cap. Exp. - (Cash spent on stock buybacks as part of employee options plan) It's probably more complicated then that, as options expenses look poised to balloon out of proportion with other costs, but this may be a decent starting point. Andrew