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

To: Pirah Naman who wrote (115)	11/10/1997 2:56:00 PM
From: jbe	Read Replies (1) \| Respond to of 253

Re: Compaq's FCF & Market Guide. Never having received a response from Market Guide to my e-mail query (reproduced in post #114), I finally called them, and got a reply from a pleasant gentleman by name of Dominic. According to Dominic, the reason that the listed price/free cash flow ratio is lower for some of the companies Market Guide covers (e.g., Compaq) than the price/cash flow ratio is that MG calculates cash flow and free cash flow differently. That is, free cash flow is determined, as you would expect, by subtracting capital expenditures and dividends from operating cash flow, as listed on the consolidated cash flow statement. But the cash flow number, and the cash flow ratio, in turn, are derived not from the cash flow statement, but from the income statement. Like our friend Andrew, MG shuns the operating cash flow number, and instead takes the net income figure as its starting point, and adds in whatever its analysts think proper to reach a cash flow number. Hence, in some cases, according to Dominic, it is indeed possible to come up with a price/free cash flow ratio that is lower than the price/cash flow ratio. However, he agrees with me that using two different standards for the cash flow ratios is very confusing for the end user of MG's materials. Apparently, I'm not the only person who has raised this issue. Another point: the ratios in the Ratio Comparisons I have been citing are calculated on a 12-month trailing basis, so obviously they won't completely correspond to the most recent 10-K. Dominic also sent me MG's complete financials for Compaq, so that I could see for myself how its cash flow calculation works out. I am not sure I can, but I will say that MG produces the completest set of financials I have ever seen, including all the data on the 10-K's balance sheet, income statement, and cash flow statement, for every year from 1986 through 1996. MG does the same for the most recent quarters, from the 9 months ending 9/30/97 (in Compaq's case) back to the 9 months ending 9/30/95. In any event,after looking at MG's numbers (which do not in any respect diverge from the 10K and 10Q numbers), and fiddling with my trusty calculator, I conclude that the price/free cash flow ratio it gives for Compaq -- 12+ -- is about right. I can't say the same for the price/cash flow number, because I don't know exactly what MG included and what it excluded when calculating cash flow from net income. But I repeat that the price/free cash flow data MG provides look fully trustworthy to me. So, once again: go, Compaq!

To: Pirah Naman who wrote (115)	11/10/1997 5:02:00 PM
From: jbe	Read Replies (1) \| Respond to of 253

RE: Compaq's FCF and Morningstar In my quest to track down the reason for all these cash flow/free cash flow discrepancies we've been encountering, I also e-mailed Morningstar.net, asking them to explain the following rather astonishing (to me) divergence (I quote): "....Looking at the 1996 10-K filed by Compaq in February, 1997, I see $3,408,000 in net operating cash flow; $342,000 in capital expenditures, leaving $3,066,000 in free cash flow....However, your Quicktake on Compaq lists only $1,232,000 for 1996 cash flow, which leaves, after the $342,000 in capital expenditures are subtracted, only $890,000 in free cash flow...." Morningstar, bless its heart, is very responsive, and I just got the following reply (quoted more or less in full; bracketed sections by jbe): "...I asked esteemed Stock Analyst journalist [sic] Haywood Kelly for help with your question, and this is what he had to say: The difference is that we do not include changes in working capital in our calculation of total cash flow. In 1996 Compaq had a big decline in inventories, which increased cash flow from operations as reported in the 10-K, and also had a big increase in accounts payable, which also boosted cash flow. Since we do not include either of these items in our cash flow, our number is much smaller than what you see in the 10-K. Depending on the company and the year, changes in working capital can be positive or negative, i.e., they can boost cash flow from operations or decrease it. Our reasoning for leaving it out of the total cash flow number is that it varies so much from year to year--for example, you can't expect Compaq to decrease its inventories sharply every year---and thus can give you a misleading take on the amount of cash a company can generate year in and year out. Another reason for leaving it out is that for fast-growing firms, the changes in working capital item is [sic] more like an investment--investment in inventory, receivables, etc.--than like a recurring cash outflow. Thus the cash flow from operations for some companies can make it look like [sic] they don't generate any cash, when in reality they do; they're just investing heavily in working capital. That said, I believe we plan on adding a line for changes in working capital in the future so people can use it or not as they see fit." END This leads me to the following comments & questions: 1) Morningstar is at least more consistent than Market Guide, in that it uses the same measure(s) for cash flow & free cash flow. 2) Although both Morningstar and Market Guide use the income statement rather than the cash flow statement to calculate cash flow, they clearly use different methods, judging from the price/cash flow ratios they come up with (not 100% comparable, I'll admit, since Morningstar's numbers refer to 1996, while MG's are more up to date): Morningstar's ratio is 39; MG's is 20. Using the 1996 operating cash flow number, I get roughly (roughly, because I'm dividing it into PRESENT capitalization) a cash flow ratio of 14 (and a free cash flow ratio of 16). 3) Such enormous discrepancies as the above are impermissible, to my mind, UNLESS the various sources make CLEAR and EXPLICIT how they calculate their numbers. Should we start a campaign demanding complete "transparency" (even from Value Line, which is arch-smug about its "proprietary methods")? 4) What do you think of Morningstar's method of calculating cash flow (and free cash flow)? 5) How can we project future cash flows, when the "experts" can't agree in their estimates of the present & the past? Talk about the Tower of Babel!